UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Suspense Accounts and the Correction of Errors
Lecture Notes
Errors generally occur because of incorrect posting to the general ledger accounts. They are classified
into two categories based on how they affect the Trial Balance agreement, that is:
1. Errors Affecting the Trial Balance Agreement
2. Errors Not Affecting the Trial Balance Agreement
Trial Balance – A tool used to test the arithmetic accuracy of entries posted to the General Ledger.
Errors Affecting the Trial Balance Agreement
These errors mean that the total of the debit columns in the Trial Balance will not be the same as the
total of the credit columns. This is so because such error breaks the rule of double entry.
For instance, suppose we have made only one error in our books. We received cash $103 on May 1,
2005 from H Singh and we enter it as:
Cash Book
2005
May 1
Cash
$
H Singh
Bank
$
103
Sales Ledger
H Singh
2005
May 1
Cash
$
13
We have put $103 on the debit side of our books, and $13 on the credit side. When we draw up the
trial balance its totals will be different by $90; i.e. $103 - $13 = $90.
Some errors that will lead to the Trial Balance not being equal include
1. Errors in extraction of the Trial Balance
2. Errors of Casting - Incorrect additions in any account
3. Errors of Transposition
4. Errors of Omission - Making an entry on only one side of the accounts e.g. a debit but no credit
5. Errors of Commission
6. Entering a different amount on the debit side from the amount on the credit side
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Errors of Transposition
An error of Transposition is when two digits in an amount are accidentally recorded the wrong way
round. For example, suppose that a sale is recorded in the sales account as $6,843, but it has been
incorrectly recorded in the total receivables account as $6,483. The error is the transposition of the 4
and the 8. The consequence is that the total debits will not be equal to total credits. You can often
detect a transposition error by checking whether the difference between debits and credits can be
divided exactly by 9. For example, $6,843 - $6,483 = $360; $360 ÷ 9 = 40.
Errors of Omission
An error of omission that affects the Trial Balance Agreement means making a debit or credit entry,
but not the corresponding double entry. Suppose a business receives an invoice from a supplier for
$300, and the trade payables account was credited, but the debit entry was omitted from the
purchases account. In this case, the total credits would not equal the total debits, because the total
debits are $300 less than they ought to be.
Errors of Commission
This is where an entry is made two times on one side of the account. For example two debit entries or
two credit entries. This will cause the Trial Balance not to agree since there will either excess debits or
excess credits.
Suspense Account
A suspense account is a temporary account which can be opened for a number of reasons. The most
common reasons are:
1. When the trial balance totals does not agree, it is made to agree by inserting the amount of the
difference between the two sides in a Suspense Account. A suspense account is opened in the
general ledger and the difference is recorded on the relevant side. See Example below:
H Mohamed and Sons
Trial Balance as on December 31, 2005
____________________________________________________________________________________
Dr.
$
200,500
Totals after all the accounts have been listed
Suspense Account
200,500
Credit
$
200,410
90
200,500
Suspense Account
2005
Dec 31 Difference per Trial Balance
LECTURE NOTES
$
90
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
2. The bookkeeper of a business knows where to post one side (e.g. Credit Side) of a transaction,
but does not know where to post the other side (e.g. Debit Side). For example, a cash payment
might be made and must obviously be credited to cash. But the bookkeeper may not know that
the payment is for, and so will not know which account to debit.
Suspense Account and Statement of Financial Position
If the errors are not found before the final accounts are prepared, the suspense account balance will
be included in the Statement of Financial Position. If the balance is a credit balance it should be
included on the Capital and Liabilities side. When the balance is a debit balance, it should be shown on
the Assets side of the Statement.
Correction of Errors
The error whenever found after a suspense account has been opened must be corrected by using
double entry. For these entries:
1. One entry must be in the suspense account
2. One entry must be in the account where the error was made
For example if the credit of $90 was an under casting of sales the journal entry to correct it is as
follows:
The Journal
Suspense
Sales
Being correction of Sales account that was understated
Debit
90
Credit
90
For all errors:
1. The double entry must be carried out, being a debit entry and a credit entry;
2. A journal entry must be made; otherwise, afterwards, it may not be possible to understand
why the entries were made in the double entry records.
You are required to open the Suspense Account to record the difference and make the relevant
Journal entry to correct each of the following:
Practice 1 – The bookkeeper of Mixem Gladly Co. made a transposition error when entering an amount
for sales in the sales account. Instead of entering the correct amount of $37,453 he entered $37,543.
Practice 2 – When Guttersnipe paid the monthly salary to its office staff, the payment of $5,250 was
correctly entered in the cash account, but the bookkeeper omitted to debit the office salaries account.
Practice 3 – A credit customer pays $460 of the $660 he owes to Ashdown Tree Felling Contractors, but
Ashdown’s bookkeeper debits $460 on the receivables account in the nominal ledger by mistake
instead of crediting the payment received.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Suspense Accounts might contain several items
If more than one error or unidentifiable posting to a ledger account arise during an accounting period,
they will all be merged together in the same suspense account. Until the causes of the errors are
discovered, the bookkeepers are unlikely to know exactly how many errors there are. As all errors are
discovered and corrected the Suspense Account should be reduced to NIL balance.
Suspense Accounts are Temporary
A Suspense Account can only be temporary. Postings to a Suspense Account are only made when the
bookkeeper doesn’t know yet what to do, or when an error has occurred. Mysteries must be solved,
and errors must be corrected. Under no circumstances should there still be a suspense account when
it comes to preparing the Statement of Financial Position of a business. The suspense account must be
cleared and all the correcting entries made before the final accounts are drawn up.
EXAMPLE
A trial balance is extracted from the books of I Legge, a fruits wholesaler at December 31, 2003
$
Capital January 1, 2003
Sales
Purchases
Inventory January 1, 2003
Overheads
Debtors
Creditors
Fixed Assets at Cost
Depreciation
Drawings
Bank
$
41,200
132,380
66,410
4,300
19,204
8,760
12,244
30,000
11,000
9,100
63,240
201,014
______
196,824
Clearly the Trial Balance does not balance and there is a difference of $4,190. To make it balance the
suspense account can be opened, thus:
Suspense Account
2003
$
Dec 31 Difference per Trial Balance 4,190
On inspection and investigation of his records the difference in the trial balance was found to be
because of the following errors:
1. A credit sale to Lemon of $264 was entered in the books as $246.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
2. A purchase from Pear of $320 was entered on Pear’s account but omitted from the purchases
account.
3. A receipt from Apple of $3,000 being a bad debt recovered was entered in the cash book but
not credited to any account.
4. A drawing of $200 was debited to drawings account as $2,000
5. A credit note to Nutt of $136 was omitted from the books altogether.
6. An invoice for $290 from G Plum was credited in error to both G Plum and H Plum.
ANSWER
THE JOURNAL
Date
Debit
$
Details
Credit
$
Trade Receivable (Lemon)
(1)
18
Sales
18
Being correction of debtor account understated
Purchases
320
Suspense
(2)
320
Being recording credit purchase deleted from
the purchases account
(3)
Suspense
Trade Receivable
3,000
3,000
Being recording of Bad debts recovered but not
credited to the Debtors
(4)
Suspense
Drawings
1,800
1,800
Being corrections of drawings account overstated
(5)
Sales Returns
Trade Receivable (Nutt)
136
136
Being correction of transaction deleted from the books
H Plum
(6)
290
Suspense
290
Being correction of credit note entered in error to creditor
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
HOME ASSIGNMENT: Draw up Ledger accounts for journal entries above and
reconstruct Trial Balance
The Effect of Errors on Profits
If an error affects items only in the Statement of Financial Position, then the original calculated profit
will not need altering. However, if the error is one of the figures shown in the Income Statement, then
the original profit will need altering.
EXAMPLE 2
At the year end of T Down & Co. an imbalance in the Trial Balance was revealed which resulted in the
creation of a suspense account with a credit balance of $1,040.
Investigations revealed the following errors.
1. A sale of goods on credit for $1,000 had been omitted from the sales account.
2. Delivery and installation costs of $240 on a new plant had been recorded as a revenue expense.
3. Cash discount of $150 on paying a supplier, JW, had been taken, even though the payment was
made outside the time limit.
4. Inventory of stationery at the end of the period of $240 had been ignored.
5. A purchase of raw materials of $350 had been recorded in the purchases account as $850.
6. The purchase returns day book included a sales credit note for $230 which had been entered
correctly in the account of the customer concerned, but included with purchase returns in the
nominal ledger.
Required:
(a) Prepare journal entries to correct each of the above errors. Narratives are not required.
(b) Open a suspense account and show the corrections to be made.
(c) Prior to the discovery of the errors, T Down and Co’s gross profit for the year was calculated at
$35,750 and the Net Profit for the year at $18,500.
ANSWER
The Journal
Date
(1)
(2)
(3)
Debit
$
Details
Suspense a/c
Credit
$
1,000
Sales
1,000
Plant
240
Delivery Cost
240
Cash discount received
150
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
JW a/c
150
(4)
Inventory of Stationery
Stationery Expense
240
(5)
Suspense a/c
Purchases
500
Purchases returns
230
Sales Returns
Suspense a/c
230
(6)
240
500
460
(b)
Suspense Account
(1)
(4)
Sales
Purchases
$
1,000
500 (6)
1,500
End of year balance
Purchases returns/sales returns
(c)
$
Gross profit originally reported
Sales omitted
Plant costs wrongly allocated
Incorrect recording of purchases
Sales credit note wrongly allocated
Adjusted gross profit
35,750
1,000
240
500
(460)
37,030
Net profit originally reported
Adjustments to gross profit $(37,030 – 35,750)
Cash discounts incorrectly taken
Stationery inventory
Adjusted net profit
18,500
1,280
(150)
240
19,870
LECTURE NOTES
$
1,040
460
1,500
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Errors Not Affecting the Trial Balance
These errors result in the same amount of debits being entered as there are credits or in no entry
being made on either the debit or credit side. This means that, if the trial balance had balanced before
the error, then it would have also balanced after the error.
The Journal
The correction of all errors should be done via the General Journal before posting to the relevant
Ledger Accounts. However, the journal is the only tool used to correct errors that does not affect the
Trial Balance. Otherwise a suspense account has to be opened first, and later cleared to a journal
entry. In fact, the journal entries should be made before completing the double entry accounts for the
transaction. The journal requires a debit and equal credit entry for each ‘transaction’, i.e. for each
correction. This means that if the total debits equal total credits before a journal is made then they
will still be equal after the journal entry is made. Similarly, if total debits and total credits are unequal
before a journal entry is made, then they will still be unequal (by the same amount) after it is made.
Errors of Commission
This is where the correct amounts are entered, but in the wrong person’s account or where a debit or
credit entry is entered in the wrong account. These usually occur where the bookkeeper makes a
mistake in carrying out his or her task in recording transactions in the accounts
Example: T Long paid us a cheque of $50 on May 18, 2005. It is correctly entered in the cash book, but
it is entered by mistake in the account for T. Lee. This means that there has been both a debit of $50
and a credit of $50. It has appeared in the personal account as:
T. Lee
2005
May 18 Bank
$
50
The error was found on May 31, 2005. We will now have to correct this. This needs two entries:
1. A debit of $50 in the account of T. Lee to cancel out the error on the credit side in that account;
2. A credit of $50 in the account of T. Long – this is where it should have been entered originally.
The account will now appear as follows:
T. Lee
2005
$
2005
$
May 31 T. Long: error corrected (1)
50 May 18 Bank
50
2005
May 1 Balance b/d
T. Long
$
2005
50
May 31 T. Lee: error corrected (2)
LECTURE NOTES
$
50
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
The Journal
2005
May 31 T. Lee
Debit
50
Credit
T. Long
50
Cash received . . . entered in wrong personal account, now corrected
Putting a debit or a credit entry in the wrong account – If telephone expenses of $540 are debited to
the electricity account, an error of commission would have occurred. The result is that although total
debits and credits balance, telephone expenses are understated by $540 and electricity expenses are
overstated by the same amount.
Errors of Principle
This is where an item is entered in the wrong type of account. An error of principle involves making a
double entry in the belief that the transaction is being entered in the correct accounts, but
subsequently finding out that the accounting entry breaks the ‘rules’ of an accounting principle or
concept. For instance, the purchase of a non-current asset or fixed asset (Capital Expenditure) should
be debited to a non-current asset or fixed asset account. If in error it is debited to a motor expense
account (Revenue Expenditure), then it has been entered in the wrong type of account.
E.g. The purchase of a motor lorry $5,500 by cheque on May 14, 2005 has been debited in error to the
motor expenses account. In the cash book it is shown correctly. This means that there has been both
a debit $5,500 and a credit of $5,500.
This will appear in the expense account as:
2005
May 14 Bank
Motor Expenses
$
5,500
The error is found on May 31, 2005. We will now correct it. Two entries are needed:
1. A debit in the motor lorry account of $5,500 to put it where it should have been entered;
2. A credit of $5,500 in the motor expenses account to cancel the error.
The accounts will now appear as follows.
2005
May 31 Motor Expenses (1)
Motor Lorry
$
5,500
2005
May 14 Bank
Motor Expenses
$
2005
$
5,500 May 31 Motor Lorry: error corrected (2) 5,500
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
The Journal
2005
May 31 Motor Lorry
Motor Expenses
Correction of error whereby purchase of motor
Lorry was debited to motor expenses account.
Debit
5,500
Credit
5,500
Similarly, suppose that the proprietor of the business sometimes takes cash out of the till for his own
personal use and during a certain year these withdrawals on account of profit amount to $280. The
bookkeeper states that he reduced the cash sales by $280 so that the cash book could be made to
balance. This would be an error of principle, and the result of it would be that the withdrawal account
is understated by$280, and so is the total value of sales in the sales account.
Errors of Original Entry
These occur where the original amount is incorrect. For instance, if a cash sale of $150 to T. Marley on
May 13, 2005 had been entered as both a debit and a credit as $130. The account will appear:
Cash
2005
May 13 Sales
$
130
Sales
2005
May 13 Cash
$
130
When the error is found on May 31, 2005 the entries needed to correct it are:
Cash
2005
$
May 13 Sales
130
May 31 Sales: error correct
20
Sales
2005
May 13 Cash
May 31 Cash: error corrected
$
130
20
The Journal
2005
May 31
Debit
20?
Cash
Credit
Sales Account
20
Correction of error: sales of $150 had been incorrectly entered as $130.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
In addition, let’s suppose total daily credit sales in the sales day book should be $28,425, but are
incorrectly added up as 28,825. The total sales in the sales day are then used to credit total sales and
debit total receivables in the ledger accounts. Although total debits are still equal, they are incorrect
by $400.
Errors of Omission
These errors are where transactions are not entered into the books or failing to record a transaction at
all. For instance, if we purchased goods from C. Richards for $250 but did not enter it in the accounts
there would be nil debits and nil credits. When we find the error on May 31, 2005 the entries to record
it will be:
2005
May 31 C. Richards: error corrected
Purchases
$
250
C. Richards
2005
May 31 Purchases: error corrected
$
250
The Journal
2005
May 31 Purchases
C. Richards
Correction of error: purchases omitted from books
Debit
250
Credit
250
Compensating Errors
These are errors that cancel out each other, that is the under or overstating of a debit and credit
balance account by the same amount. They are errors which are coincidentally, equal and opposite of
one another. Let us take a case where the sales journal is added up to be $100 too much. In the same
period the purchases journal is also added up to be $100 too much. If these were the only errors in our
books, the trial balance totals would equal each other. Both totals would be wrong – they would both
be $100 too much – but they would be equal. If in fact the incorrect totals had purchases $7,900 and
sales $ 9,900, the accounts would have appeared as:
Sales
2005
$
May 31 Sales Journal
9,900
Purchases
2005
$
May 31 Purchases Journal
7,900
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
When corrected, the accounts will be:
2005
May 31 the Journal: error corrected
Sales
$
2005
100 May 31 Sales Journal
$
9,900
2005
May 31 Purchases Journal
Purchases
$
2005
7,900 May 31 the Journal: error corrected
$
100
The journal entries to correct these two errors will be:
The Journal
2005
May 31 Sales account
Purchases
Correction of compensating error: totals of both
Purchases and sales journals incorrectly added
up $100 too much
Debit
100
Credit
100
Complete Reversal of Entries
The correct amounts are entered in the correct accounts, but each item is shown on the wrong side of
each account. There has been both a debit and credit entry of equal amounts. For instance, a cheque
for $200 paid to D Charles was debited in the cash book and credited in D Charles account.
2005
May 28 D Charles
2005
Cash
$
Cash Book (A)
Bank
$
2005
200
D. Charles (A)
$
2005
May 28 Bank
This is incorrect. It should have been as follows:
1. Debit: D Charles $200
2. Credit: Bank $200
LECTURE NOTES
Cash
$
Bank
$
$
200
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Both items have been entered in the correct accounts, but each on the wrong side of its account.
Correction of such an error is more difficult to understand than other errors. Let us look at how the
items would have appeared if we had done it correctly in the first place. We will show the letter (B)
behind the account names:
Cash Book
Cash Bank
Cash Bank
2005
$
$
2005
$
$
May 28 D Charles
200
2005
May 28 Bank
D. Charles
$
2005
200
$
When we found the error on May 31, by using double entry we have to make the amounts shown to
cancel the error be twice the amount the error. This is because we need to do the following:
1. We have to cancel the error; this means entering the following amounts
Debit: D Charles
$200
Credit: Bank
$200
2. We have to now correctly enter the transaction
Debit: D Charles
$200
Credit: Bank
$200
All together, then, the entries to correct the error are twice the amounts first entered. When corrected
the accounts appear as follows, marked (C):
Cash Book
Cash Bank
Cash Bank
2005
$
$
2005
$
$
May 28 D. Charles
200 May 31 D Charles: error corrected
400
2005
May 31 Bank: error corrected
D. Charles
$
2005
400 May 28 Bank
LECTURE NOTES
$
200
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
You can see that accounts (C) give the same final answer as accounts (B):
$
(B) Debit: D. Charles
Credit: Bank
(C) Debit: D. Charles (400 – 200)
Credit: Bank (400 – 200)
$
200
200
200
200
The Journal
2005
May 31 D. Charles
Bank
Payment of $200 on May 28, 2005 to D. Charles
incorrectly credited to his account, and debited to
bank: error now corrected.
Debit
400
Credit
400
Casting
You will often notice the use of the expression ‘to cast’, which means to add up. Overcastting means
incorrectly adding up a column of figures to give an answer that is greater that it should be; under
casting means incorrectly adding up a column of figures to give an answer than is less than it should be.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Suspense Accounts and the Correction of Errors
Worksheet1
QUESTION 1
The trial balance of Dick and Doris at 31.12.04 showed:
Dick
Dr
Capital 1.1.04
Inventory 1.1.04
Purchases and sales
Expenses
Drawings
Receivables and Payables
Fixed Assets at Cost
Depreciation to 31.12.04
Bank
2,567
15,908
6,200
5,700
3,400
12,700
Doris
Cr
12,608
28,981
2,300
Dr
3,510
40,700
17,500
10,322
15,680
10,438
6,230
4,006
Cr
23,876
70,432
5,600
3,428
4,810
For Dick, the following errors were found:
a)
b)
c)
d)
Drawings of $200 were debited in error to expense.
Purchased goods $36 from Fred, a supplier, and debited to his account.
The sum due from Alf was omitted from the trial balance - $80.
Drawings by Dick of inventory valued at $45 were made in June 2004 and not recorded in
the books.
e) A payment of casual wages $80 was entered in the cash book but the double entry was not
completed.
f) Non Current Assets purchases of $380 were entered as $830 in the Non Current Assets
Account.
For Doris, the following errors were found:
a) The account of Joshua, a customer was extracted in error as $354 instead of $454.
b) A payment for advertising $190 was credited in the expenses account.
c) An invoice for goods purchased for resale from Wally $278 was omitted from the books
altogether.
d) The sales invoice to Hodge was correctly entered in the sales day book as $560 but entered
in the Hodge’s account as $650.
e) The payment of an advertising account to Noos Ltd $50 was debited in the expenses
account and also in Noos Ltd account. The Original invoice was correctly entered in Noos Ltd
account.
f) The balance of Geoff’s account was entered as $320 Debit In fact the two sided of his
account totaled DR $890 CR $534.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Required for each business:
a) Compute the difference of the trial balance (suspense account).
b) Identify and correct the errors.
c) Produce an amended trial balance and show that it now balances.
Question 2
The following errors in the books of J. Holt have been found.
a) Equipment bought $2,500 by cheque has been debited to general expenses account.
b) $149 received from E. Grey has been correctly entered in the cash book but debited to Grey’s
account.
c) Goods sold $973 to J. Crook have been entered in error as $937.
d) A discount allowed to P. Paul of $44 has been debited to the discounts allowed account as
$144.
e) $135 goods bought from D.D. Ltd have been credited to B.B Ltd.
From the above you are to:
State how each error affects the agreement of the trial balance totals;
1) State which errors will affect net profits, and how.
2) State which errors will affect gross profits, and how.
3) State which of the above is:
a) An error of principle?
b) An error of commission?
c) An error of original entry?
f) Show the journal entries needed to correct each error – narratives are required.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Question 3
The following is a trial balance, which has been incorrectly drawn up.
Trial Balance as at 31 January 2009
Capital 1 February 2008
Drawings
Inventory 1 February 2008
Trade Receivables
Furniture and fittings
Cash in hand
Trade Payables
Sales
Sales Returns
Discount received
Business expenses
Purchases
$
5,500
2,800
$
2,597
2,130
1,750
1,020
2,735
7,430
85
46
950
4,380
16,446
14,977
In addition to the mistakes evident above, the following errors were also discovered.
a) A payment of $75 made to a creditor had not been posted from the cash book into the
payables ledger.
b) A cheque for $56 received from a customer had been correctly entered in the cash book but
posted to the customer’s account as $50.
c) A purchase of fittings $120 had been included in the purchases account.
d) The total of the discounts allowed column in the cash book of $38 had not been posted into the
nominal ledger.
e) A page of the sales day book was correctly totaled as $564 but carries forward as $456.
Show the trial balance as it would appear after all the errors had been corrected. You are required to
show all working.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Control Account
Lecture Notes
A Control Account is an account that checks the arithmetic accuracy of the Nominal Ledger. It is a
composition of different ledger account balances. Control accounts are used chiefly for trade
receivables and payables:

A Receivable Control Account is an account in which records are kept of transactions involving
all receivables in total. The balance on the receivables control account at any time will be the
total amount due to the business at that time from its receivables.

A Payables Control Account is an account in which records are kept of transactions involving all
payables in total, and the balance on this account at any time will be the total amount owed by
the business at that time to its payables.
Other Control Accounts
Although control accounts are used mainly in accounting for receivables and payables, they can also be
kept for other items, such as inventories, wages and salaries, and cash. The most important idea to
remember, however, is that a control account is an account which keeps a total record for a collective
item (e.g. receivables), which in reality consists of many individual items (e.g. individual trade accounts
receivable).
Control Accounts and Personal Accounts
The personal accounts of individual customers of the business are kept in the receivables ledger, and
the amount owed by each receivable will be a balance on his personal account. The amount owed by
all the receivables together (i.e. all the trade account receivables) will be a balance on the receivables
control account.
At any time the balance on the receivables control account should be equal to the sum of the
individual balances on the personal accounts in the receivables ledger.
A control account is however an (impersonal) ledger account which will appear in the nominal ledger.
Control Accounts; another form of Trial Balance
A trial balance is usually drawn up to test the arithmetical accuracy of the accounts, but there are
certain errors that are not revealed by such a trial balance. If the trial balance totals disagreed, for a
small business the books could be easily and quickly checked so as to find the errors. However, when
the firm has grown and the accounting work has been divided up so that there are several or many
ledgers. Any errors could be very difficult to find. We would have to check every item in every ledger.
What is required is a type of trial balance for each ledger, and this requirement is met by the Control
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Account. This ensures that it is only the ledgers whose control accounts do not balance that need
detailed checking to find errors.
The Principle of Control Accounts
The principle on which control accounts is based is as follows: If the opening balance of an account is
known, together with the information of the additions and deductions entered in the account, the
closing balance can be calculated.
Example
Receivables Ledger
2002
May 1
May 4
May 30
2002
May 1
May 28
2002
May 1
May 15
2002
May 1
Balance b/d
Sales
Sales
Balance b/d
Sales
Balance b/d
Sales
Balance b/d
T. Sangster
$
2002
850 May 7
900 May 7
350 May 31
2,100
P. Mayall
$
2002
1,500 May 9
400 May 14
May 14
May 31
1,900
K. Wingfield
$
2002
750 May 20
600 May 31
1,350
C. Shenton
$
2002
450 May 28
450
LECTURE NOTES
Bank
Discount Allowed
Balance c/d
$
820
30
1,250
2,100
Sales Returns
Bank
Discount Allowed
Balance c/d
$
200
900
20
780
1,900
Sales Returns
Balance c/d
$
110
1,240
1,350
Bad Debts
$
450
450
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
A control account, in this case a Receivables Control Account, would consist only of the totals of each of
the items in the receivables ledger:
May 1 Balance b/d:
$850 + $1,500 + $750 + $450 = $3,550
Sales in May:
$900 + $350 + $400 + $600 = $2,250
Cheques received in May:
$820 + $900 = $1,720
Discounts allowed in May: $30 + $20 = $50
Sales Returns in May:
$200 + $110 = $310
Bad Debts written off in May: $450
Now looking at the totals it is possible to draw up a receivables control account. Debits are shown as
usual on the left-hand side, and credits on the right-hand side.
Receivables Control Account
2002
$
2002
$
May 1
Balance b/d
3,550 May 31 Sales Returns
310
May 31 Sales for the Month
2,250 May 31 Bank
1,720
May 31 Discount Allowed
50
May 31 Bad debts
310
May 31 Balance c/d
3,270
5,800
5,800
When the balance c/d of the receivables control account ($3,270) is matched with the sum of the
balance c/d in the receivables ledger ($1,250 + $780 + $1,240 = $3,270), it proves that the entries
made in the receivables ledger are correct.
The Purpose of Control Accounts
1. The main purpose of a control account is to act as a check on the accuracy of the entries made
in the receivables ledger and payables ledger. The total of a list of all the balances extracted
from the ledger should equal the balance on the control account. If not, a mistake, or even
many mistakes, may have been made and will have to be found.
2. The control accounts also assist in the location of errors, where postings to the control
accounts are made daily or weekly or even monthly. It would be a formidable task to locate
errors at the end of a year, say, given the number of transactions. By using the control account,
a comparison with the individual balances in the receivables and payables ledger can be made
for every week or day of the month, and the error found much more quickly than if control
accounts did not exist.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
3. Where there is a separation of clerical (bookkeeping) duties, the control account provides an
internal check. The person posting entries to the control accounts will act as a check on a
different person (s) whose job it is to post to the receivables and payables ledger accounts.
4. To provide total receivables and payables balances more quickly for producing a trial balance or
Statement of Financial Position. A single balance on a control account is obviously extracted
more simply and quickly than many individual balances in the receivables or payables ledger.
This means also that the number of accounts in the double entry bookkeeping system can be to
a manageable size, since the personal accounts are memorandum accounts only.
The Agreement of the Control Account and the Ledgers
The control accounts should be balanced regularly (at least monthly), and the balance on the account
agreed with the sum of the individual debtors or suppliers balances extracted from the receivables or
payables ledgers respectively. If the balances do not agree it maybe because of one or more of the
following reasons:
1. An incorrect amount may be posted to the control account because of a miscast of the total in
the books of original entry (i.e. adding up incorrectly the total value of invoices or payments).
The nominal ledger debit and credit postings will then balance, but the control account balance
will not agree with the sum of individual balances extracted from the (memorandum)
receivables ledger or payables ledger. A journal entry must then be made in the nominal
ledger to correct the control account and the corresponding sales or expense account.
2. A transposition error may occur in posting an individual’s balance from the books of prime
entry to memorandum ledger, e.g. a sale to C Cloning of $250 might be posted to his account as
$520. The sum of the balances extracted from the memorandum must be corrected. No
accounting entry would be required to do this, except to alter the figure in C Cloning’s account.
3. A transaction may be recorded in the control account and not in the memorandum ledger, or
vice versa. This requires an entry in the ledger that has been missed out which means a double
posting if the control account has to be corrected, and a single posting if it is the individual’s
balance in the memorandum that is at fault.
4. The sum of balances extracted from the memorandum ledger may be incorrectly extracted or
miscast. This would involve simply correcting the total of the balances.
It should be noted that The Personal Accounts in the receivables ledger are memorandum accounts,
because they are not a part of the double entry system.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Control Account Flow Chart of Receivables
B = $150
B = $200
Cheques
received
A = $120
Invoices
A = $100
Sales Day Book
$
A
100
B
200
Total
300
Receivables Ledger
[Personal Accounts]
A
B
100 120
200 150
=$20 Cr
= $50 Dr
Overall Balance
* = $30 Dr
Sales Account
Receivables Account
[Control A/c)
$
Dr Total Sales 300
Dr Total Cash 270
Balance
* 30 Dr
Cr Total Sales
$300
LECTURE NOTES
Cash Book
$
A
120
B
150
Total $ 270
Cash Account
Cr Total Cash
$270
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Information for Control Accounts
Information is found in the following places to draw up the control accounts
Receivables Control Account
Source
1. Opening Trade Receivables
List of individual receivables balances drawn up at the end of
previous period. Opening Trade Receivables in the Statement of
Financial Position.
2. Credit Sales
Total from Sales Day Book
3. Sales Returns
Total from Sales Returns Day Book
4. Cheques Received
Cash book: cash column on received side. List extracted or total
of a special column which has been included in the cash book.
5. Cash Received
Cash book: cash column on received side. List extracted or total
of a special column which has been included in the cash book.
6. Closing Trade Receivables
List of individuals receivables balances drawn up at end of the
current period.
7. Discount Allowed
Receipts side of the Cash Book
Payables Control Account
Source
1. Opening Trade Payables
List of individual payables balances drawn up at the end of
previous period. Opening Trade Payables in the Statement of
Financial Position.
2. Credit Purchases
Total from Purchases Day Book
3. Purchases Returns
Total from Purchases Returns Day Book
4. Cheques Paid
Cash book: bank column on payments side. List extracted or total
of a special column which has been included in the cash book.
5. Cash Paid
Cash book: cash column on payments side. List extracted or total
of a special column which has been included in the cash book.
6. Closing Trade Payables
List of individual payables balances drawn up at end of the
current period.
7. Discount Received
Payments side of the cash book
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Opening and Closing Balances
The opening balance in the receivable control and payables control account will be on the debit side
and credit side respectively, which is similar to the receivables ledgers and the payables ledger.
Opening credit balances which would have been closing debit balances in the previous period are
unusual in the receivables control account. They however represent debtors to whom the business
owes money, probably as a result of the over-payment of debts or for advance payment of debts for
which no invoices have yet been sent. Likewise, opening debit balances and closing credit balance in
the payables control account would represent suppliers who owe the business money, perhaps
because the business has overpaid or because a credit note is awaited for returned goods.
Other Transfers
Bad Debts
Transfers to bad debts accounts will have to be recorded in the receivables control account as they
involve entries in the receivables ledgers.
Contra Entries
A contra entry is whereby the same firm is both a supplier and customer and inter-indebtedness is set
off. This will also need to be entered in the control accounts. An example of this is as follows:
1.
2.
3.
4.
The firm has sold A. Hope $600 goods on May 1, 2005
Hope has supplied the firm with $880 goods on May 12, 2005
The $600 owing by Hope is set off against $600 owing to him on May 30, 2005.
This leaves $280 owing to Hope on May 31, 2005
2002
May 1
Sales
(1)
Receivables Ledger
A. Hope
$
2002
600 May 30 Set-off: Payables Ledger (3)
600
2002
May 30
May 31
Set-off: Rec. Ledger
Balance c/d
(3)
(4)
Payables Ledger
A. Hope
$
2002
600 May 12
280
880
LECTURE NOTES
$
600
600
Purchases
(2)
$
880
880
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
The transfer of the $600 will therefore appear on the credit side of the receivables control account and
on the debit side of the payables control account. Relevant entries must be made in the journal.
When doing contra entry (set-offs) in the control you have to think of it as cash received and cash paid,
for the entries go on the same sides of the control account as these items. Thus a contra item will
appear on the credit side of the receivables control account (the same side as cash received from trade
receivables) and will appear on the debit side of the payables control account (the same side as cash
paid to creditors would appear).
Exercise
2006
$
Aug 1 Receivables Ledger: Debit Balances
Aug 1 Receivables Ledger: Credit Balances
Aug 31 Transactions for the month:
Cash Received
Cheques received
Sales
Discount Allowed
Return Inwards
Cash refunded to a customer who had overpaid her account
At the end of the month:
Receivables Ledger: Debit Balances
Receivables Ledger: Credit Balances
2006
Aug 1
Aug 31
Balance b/d
Sales for the Month
Cash Refunded
Balance c/d
Receivables Control Account
$
2006
3,816 Aug 1
Balance b/d
7,090 Aug 31 Cash
37
Bank
40
Discount Allowed
Return Inwards
Balance c/d
10,983
LECTURE NOTES
3,816
22
104
6,239
7,090
298
164
37
4,156
40
$
22
104
6,239
298
164
4,156
10,983
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Control Account
Worksheet 2
1. You are to prepare a receivables control account from the following. Deduce the closing figure
of sales ledger balances as at 31 March 2008.
2008
Mar 1
$
6,708
Receivables ledger balance
Total for March:
Discounts allowed
Cash and cheques received from debtors
Sales Day Book
Bad debts written off
Sales Returns Day Book
Mar 31 Receivables ledger balances
300
8,970
11,500
115
210
?
2. You are to prepare a payables control account from the following. As the final figure of
payables ledger balances at 30 November is missing, you will have to deduce that figure.
2004
Nov 1 Payables ledger balance
$
7,560
Total for November:
Discounts received
Purchases Returns Day Book
Cash and cheques paid to payables
Purchases Day Book
Nov 30 Payables ledger balances
240
355
9,850
11,100
?
3. Prepare a receivables control account from the following.
2005
May 1 Debit balances
$
6,420
Total for May:
Sales Day Book
Cash and cheques received from debtors
Discounts allowed
Debit balances in the receivables
ledger set off against credit
balances in the payables ledger
May 31 Receivables ledger balances
Credit balances
LECTURE NOTES
12,800
10,370
395
145
?
50
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Single Entry and Incomplete Records
Lecture Notes
Incomplete records problems occur when a business does not have a full set of accounting records, for
one of the following reasons:
 The proprietor of the business does not keep a full set of accounts.
 Some of the business accounts are accidentally lost or destroyed.
Given the above situations, the problem for the accountant is to prepare a set of year-end accounts for
the business; i.e. an Income Statement and a Statement of Financial Position from incomplete
information. Since the business does not have a full set of accounts, preparing the final accounts is not
a simple matter of closing off accounts and transferring balances to the Trading, Income and Expense
Account, or showing outstanding balances in the Statement of Financial Position. The task of preparing
the final accounts involves the following:
(a) Establishing the cost of purchases and other expenses
(b) Establishing the total amount of sales
(c) Establishing the amount of accounts payable, accruals, accounts receivable and prepayments at
the end of the year.
The great merit of incomplete records problems is that they focus attention on the relationship
between cash received and paid, sales and accounts receivable, purchases and accounts payable,
inventory, as well as calling for the preparation of final accounts.
In Accounting, the Double Entry Principle is very critical for keeping complete records to produce
financial statements. However, small businesses owners are not always aware of this principle. As
such, they may tend to document the transactions that occur in their business in a diary format. In
addition, they may also leave out certain critical information that is important to producing financial
information. This information may be needed for different reasons such as, obtaining credit, accessing
a loan, income tax purposes or accessing the performance of the business. As such, the accountant has
to use the Single Entry and Incomplete Records approach to calculate the business’ profit. One way is
to see “Profit as an Increase in Capital”.
Profit as an Increase in Capital – The Business Equation
Unless there has been an introduction of extra cash or resources into the firm, the only way that
capital can be increased is by making profits. Therefore, profits can be found by comparing capital at
the end of the last period with that at the end of this period.
For instance, if a firm’s capital at the end of 2004 was $2,000 and 2005 it was $3,000 with no extra
resources introduced or withdrawn (drawings) then:
Net Profit
=
This Year’s
Capital
$3,000
-
Last Year’s
Capital
$2,000
=
LECTURE NOTES
$1,000
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
If there had been drawings of $700, then the profits would have been calculated as follows:
This Year’s
Capital
$3,000
=
Last Year’s
Capital
$2,000
Net Profit
+
?
Drawings
-
$700
If the above formula is transposed to find the missing figure then profits will be:
$2,000
-
$3,000
+
$700 =
$1,700
Example
H. Williams has not kept proper bookkeeping records, but he has kept notes in diary form of the
transactions of his business. He is able to give to you details of his assets and liabilities as at December
31, 2005 and at December 31, 2006 as follows:
At December 31, 2005:
Assets: Motor Van $1,000; Fixtures $700; Inventory $850; Trade Accounts Receivables $950; Bank
$1,100, Cash $100
Liabilities: Trade Payable $200; Loan from J Austin $600
At December 31, 2006:
Assets: Motor Van (after depreciation) $800; Fixtures (after depreciation) $630; Inventory $990; Trade
Accounts Receivables $1,240; Bank $1,700, Cash $200
Liabilities: Trade Payable $300; Loan from J Austin $400; Drawings $900
A Statement of Affairs will have to be drawn up as at 2005 and 2006. A Statement of Affairs is a
statement from which the capital is deduced by estimating assets and liabilities.
Then Capital = Assets – Liabilities.
H. Williams
Statement of Affairs as at December 31, 2005
Non Current Assets
Motor Van
Fixtures
$
Current Assets
Inventory
Trade Accounts Receivables
Bank
Cash
$
1,000
700
1,700
850
950
1,100
100
3,000
4,700
Total Assets
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
H. Williams
Statement of Affairs as at December 31, 2005
Capital and Liabilities
Proprietor’s Capital (difference)
3,900
Non-Current Liabilities
Loan from J Austin
600
Current Liabilities
Trade Accounts Payable
Total Capital and Liabilities
200
4,700
H. Williams
Statement of Affairs as at December 31, 2006
Non-current Assets
Motor Van
Fixtures
$
Current Assets
Inventory
Trade Accounts Receivables
Bank
Cash
$
800
630
1,430
990
1,240
1,700
200
4,130
5,560
Total Assets
Capital and Liabilities
Proprietor’s Capital
Balance as at Jan 1, 2006
Add Net Profit
(C)
(B)
Less Drawings
(A)
Non-Current Liabilities
Loan from J Austin
Current Liabilities
Trade Accounts Payable
Total Capital and Liabilities
LECTURE NOTES
3,900
1,860
5,760
900
4,860
400
300
5,560
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Opening Capital + Net Profits – Drawings = Closing Capital
We will have to find the profit by working backwards:
(A) is Non-Current Liabilities + Current Liabilities – Total Assets = $5,260 – $400 = $4,860
(B) is (A [Closing Capital]) + Drawings = $4,860 + $900 = $5,760
(C) is (B) – Opening Capital = $1,860
This method of calculating profits is unsatisfactory as it is much more informative when an Income
Statement can be drawn up. A business would have exactly the same Income Statement and
Statement of Financial Position whether they kept their books by single entry or by double entry.
However, whereas the double entry uses the trial balance in preparing the final accounts, the single
entry will have to arrive at the same answer by the following five steps using the example of J. Frank:
The accountant discerns the following details of transactions for J. Frank’s retail store for the year
ended December 31, 2005:
1. The sales are mostly on a credit basis. No record of sales has been made, but $10,000 has been
received $9,500 by cheque and $500 by cash, from persons to whom goods have been sold.
2. Amount paid by cheque to suppliers during the year =$7,200.
3. Expenses paid during the year: by cheque, rent $200, general expenses $180; by cash rent $50
4. J. Frank took $10 cash per week (for 52 weeks) as drawings.
5. Other information available:
Trade Accounts Receivables
Trade Accounts Payables
Rent owing
Bank balance
Cash Balance
Inventory
At Dec. 31, 2004
$
1,100
400
1,130
80
1,590
At Dec. 31, 2005
$
1,320
650
50
3,050
10
1,700
6. The only Non-Current Asset consists of fixtures which were valued at December 31, 2004 at
$800. These are to be depreciated at 10% per annum.
The approach to incomplete records questions is to build up the information given so as to complete
the necessary double entry. This may involve reconstructing control accounts for:
 Cash and Bank
 Trade Accounts Receivable and Payable
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Stage 1 – Determine the Opening Position of the Company
Draw up an Opening Statement of Financial Position to determine the company’s opening position.
This would also be the company’s financial position at the closing day of the last financial period.
J. Frank
Statement of Financial Position as at December 31, 2004
Non-Current Assets
Fixtures
$
Current Assets
Inventory
Trade Accounts Receivable
Bank
Cash
$
800
1,590
1,100
1,130
80
3,900
4,700
Capital and Liabilities
Proprietor’s Capital (difference)
4,300
Current Liabilities
Trade Accounts Payable
Total Capital and Liabilities
400
4,700
Stage 2 – The Cash Book
Information about cash receipts or payments might be needed to establish:
(a) The amount of purchases during a period
(b) The amount of credit sales during a period
Other items of receipts or payments might be relevant to establishing:
(a) The amount of cash sales
(b) The amount of certain expenses in the Income Statement
(c) The amount of withdrawals on the account of profit by the business proprietor
A small business will not keep a day-to-day record of its cash receipts and payments (cash book), since
many of its sales and payment transactions are for cash (i.e. notes, coins, cheques, or credit cards).
However, where there appears to be a sizeable volume of receipts and payments in cash (i.e. notes and
coins), then it would be helpful to construct a two column cash book.
Two Column Cash Book is a cash book with one column for receipts and payments, and one for money
paid into and out of the business bank account.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
A cash and bank summary is drawn up showing the totals of each separate item plus opening and
closing balances:
Cash
Bank
Cash
Bank
$
$
$
$
Balance b/d
80 1,130 Suppliers
7,200
Receipt from Receivables
500 9,500 Rent
50
200
General Expense
180
Drawings
520
Balance c/d
10
3,050
580 10,630
580 10,630
Theft of cash from the till
When cash is stolen from the till, the amount stolen will be a credit entry in the cash book, and a debit
in the either the net profit section (Income and Expenses Account) of the Income Statement or
insurance claim account, depending on whether the business is insured. The missing figure for the
cash sales, if this has to be calculated, must not ignore cash received but later stolen.
Stage 3 – Calculate Purchases and Sales Figures
It is necessary to calculate the figures for sales and purchases to be shown in the trading account.
Credit Sales and Trade Accounts Receivable
If a business does not keep a record of its sales on credit, the value of these sales can be derived from
the opening balance of trade accounts receivable, the closing balance of trade accounts receivable, and
the payments received from customers during the period. The sales figure will only equal receipts
where all the sales are for cash. Therefore, the receipts figures need adjusting to find sales. This can
only be done by constructing a receivables control account, the sales figure being the one needed to
make the totals agree or using the following formula:
Formula for Credit Sales
Payments from trade accounts receivable
Less Opening balance of trade accounts receivable (these represent sales in a
previous period)
Add Closing balance of trade accounts receivable (since these represent sales
in the current period for which cash payments has not yet been received)
The receivables control account usually looks like the receivables ledger account.
Receivables Control Account
$
Balance b/d
1,100 Receipts: Cash
Sales (missing figure)
10,220
Cheque
Balance c/d
11,320
LECTURE NOTES
X
(X)
X
X
$
500
9,500
1,320
11,320
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Irrecoverable Debts (Bad Debts)
If there are irrecoverable debts during the period, the value of sales will be increased by the amount of
irrecoverable debts written off, no matter whether they relate to opening receivables or credit sales
during the current period.
The same interrelationship between credit sales, cash from receivables, and opening and closing
receivables balances can be used to derive a missing figure for cash from receivables, or opening or
closing receivables, given the values for the three other items. For example, if we know that opening
receivables are $7,600, closing receivables are $3,200 and credit sales for the period are $69,400, then
cash from receivables during the period would be as follows:
Opening Balance b/d
Sales (on credit)
Receivables Control Account
$
6,700 Cash Receipts (Balancing Figure)
69,400 Closing Balance c/d
76,100
$
72,900
3,200
76,100
An alternative way of presenting the same calculation would be:
Opening balance of accounts receivable
Credit Sales during the period
Total Money owed to the business
Less Closing balance of accounts receivable
Equals cash received during the period
6,700
69,400
76,100
(3,200)
72,900
Purchases and Trade Accounts Payable
A similar relationship exists between purchases of inventory during a period, the opening and closing
balances for trade accounts payable, and amounts paid to suppliers during the period. In double entry,
purchases mean the goods that have been bought in the period, irrespective of whether they have
been paid for or not during that time. The figure of payments to suppliers must therefore be adjusted
to find the figure for purchases. If we wish to calculate an unknown amount for purchases, the amount
would be as follows:
Payments to Trade Accounts Payable
Less Opening balance on trade accounts payable (these debts, paid in the current period,
Relate to purchases in a previous period)
Add Closing balance of trade accounts payable (since these represent purchases
in the current period for which payment has not yet been made)
Goods bought in this year, that is purchases
LECTURE NOTES
X
(X)
X
X
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
Paid during the year
Less payments made, but which were for goods
which were purchased in a previous (payables 31/12/2004)
Add purchases made in this year, but for which
Payments has yet not been payment (creditors 31/12/2005)
Goods bought in this year, that is purchases
TROY J. WISHART
7,200
400
6,800
650
7,450
The same answer could have been obtained if the information had been in the form of a payables
control T-account, the figure for purchases being the amount required to make the account totals
agree.
Cash paid to suppliers
Balance c/d
Payables Control Account
$
7,200 Balance b/d
650 Purchases (missing figure)
7,850
$
400
7,450
7,850
Stage 4 – Calculate Expenses
Where there are no accrued or prepaid expenses, either at the beginning or end of the accounting
period, then expenses paid will equal expenses used up during the period. These figures will be
charged to the Income Statement.
On the other hand, where such prepayments or accruals exist, then an expense account should be
drawn up for that particular item using the opening balance b/f, the closing balance c/f and cash
payments for the item during the period. A prepayment in the expense account will have a debit
opening balance b/f since it is a current asset. On the other hand, an accrual in the expense account
will have a credit opening balance b/f since it is a current liability.
When all known items are entered, the missing figure will be the expenses to be charged for the
accounting period. In this case, only the rent account needs to be drawn up.
Rent
$
$
Cheques
200 Rent (missing figure)
300
Cash
50
Accrued c/d
50
300
300
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Stage 5 – Produce Closing Financial Statements
It is now practicable to produce closing financial statements since key figures have been found.
J. Frank
Income Statement for the year ended December 31, 2005
$
Sales (Stage3)
Less Cost of Goods Sold:
Opening Inventory
Add Purchases (Stage 3)
Less Closing Inventory
Gross Profit
Less Expenses
Rent (Stage 4)
General expense
Depreciation
Net Profit
1,590
7,450
9,040
1,700
300
180
80
$
10,220
7,430
2,880
560
2,320
H. Williams
Statement of Affairs as at December 31, 2006
Non-Current Assets
Fixtures
Less Depreciation
$
800
80
Current Assets
Inventory
Trade Accounts Receivables
Bank
Cash
$
720
1,700
1,320
3,050
10
6,080
6,800
Total Assets
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
H. Williams
Statement of Affairs as at December 31, 2006
Capital and Liabilities
Proprietor’s Capital
Balance as at Jan 1, 2005 (Stage 1)
Add Net Profit
4,300
2,320
6,620
520
6,100
Less Drawings
Current Liabilities
Trade Accounts Payables
Rent Owing
Total Capital and Liabilities
650
50
700
6,800
Disadvantages of Single Entry Recording
Someone without a double entry set of books will not be able to ascertain the following easily

Trade Receivables – They will not know who owes money, how much and how long the money
has been owed.
 Trade Payables – They will not know to whom they owe money, how much and how long it has
been owed.
 No proper checks on amounts paid – for non-current assets over the years.
 No proper checks on amounts owing – for loans.
It will also make it easier for employees to defraud the business, e.g. by destroying sales invoices and
getting money from the debtor for doing this.
A More Comprehensive Approach to Incomplete Records
Step 1 – If possible, and if it is not already known, establish the Opening Statement of Financial
Position and the Proprietor’s Interest (Capital).
Step 2 – Open up accounts for a two column cash book (if cash sales are significant and there are payments in
cash out of the till), a trade receivable Control Account, a trade payables control account.
Step 3 – Enter the opening balances in these accounts.
Step 4 – Work though the information you are given line by line; and each item should be entered into the
appropriate account if it is relevant to one or more of these four accounts.
You should also try to recognize each item as an ‘income or expense item or a ‘closing statement of
financial position item’.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
It may be necessary to calculate an amount for withdrawals on account and an amount for noncurrent asset depreciation.
Step 5 – Look for the balancing figures in your accounts. In particular you might be looking for a
value for credit sales, cash sales, purchases, the cost of goods sold, the cost of goods
stolen or destroyed, or the closing bank balance. Calculate these missing figures, and
make any necessary double entry (e.g. to the trading account from trade accounts
payable for purchases, to the trading account from the cash book for cash sales, and to
the trading account from trade accounts receivable for credit sales).
Step 6 – Now complete the income statement and statement of financial position. Working T-accounts might
be needed where there are accruals and prepayments.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Single Entry and Incomplete Records
Worksheet
1. On 1 August 2006 S. Phillips started his business with $1,000 in his bank account. After the end
of his first year of trading he realized that, because of his lack of bookkeeping knowledge, he
was unable to prepare a statement of financial position. He was, however, able to produce the
following data for the year ended 31 July 2007.
Furniture
Motor vehicles (cost $2,100)
Inventory
Trade Accounts Payable
Cash in hand
Balance at bank (overdrawn)
Trade Accounts Receivable
Loan from B. Smith
Drawings
$
800
1,600
2,700
3,300
50
1,000
1,600
200
3,000
You are required to:
(a) ascertain his profit or loss for the year ended 31 July 2007;
(b) prepare his Statement of Financial Position as at 31 July 2007, showing clearly all the
totals and subtotals normally found in a such a statement.
2. J. Marcano is a dealer who has not kept proper books of account. At 31 August 2006 her state
of affairs was as follows.
Cash
Bank balance
Fixtures
Inventory
Trade Accounts Receivables
Trade Accounts Payable
Motor van (at valuation)
$
115
2,209
3,500
16,740
11,890
9,952
3,500
During the year to 31 August 2007 her drawings amounted to $7,560. Winnings from a
football pool $12,800 were put into the business. Extra fixtures were bought for $2,000.
At 31 August 2007 J. Marcano’s assets and liabilities were: cash, $84; bank overdraft,
$165; inventory, $24,891; trade payables for goods, $6,002; payables for expenses,
$236; fixtures to be depreciated, $300; motor van to be valued at $2,800; trade
receivables, $15,821; prepaid expenses, $72.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Draw up a statement showing the profit or loss made by Marcano for the year ended 31
August 2007.
3. A Hernandez is a sole trader who, although keeping very good records, does not operate a full
double entry. The following figures have been taken from her records.
Cash at bank
Office furniture
Inventory
Cash in hand
31 March 2008
$
1,460
600
2,320
60
31 March 2009
$
1,740
500
2,620
80
Trade Accounts Receivable on 31 March 2008 amounted to $2,980 and sales for the
year ended 31 March 2009 to $11,520. During the year ended 31 March 2009 cash
received from receivables amounted to $10,820.
Trade Accounts Payables on 31 March 2008 amounted to $1,880 and purchases for the
year ended 31 March 2009 to $8,120. During the year ended 31 March 2009 cash paid
to trade payables amounted to $7,780.
During the year to 31 March 2009 no bad debts were incurred. Also, during the same
period there was neither discount allowed nor discount received.
Required:
Calculate receivables and payables as at 31 March 2009;
(a) calculate Hernandez’ capital as at 31 March 2008 and 31 March 2009;
(b) calculate her net profit for the year ended 31 March 2009, allowing for the fact that
during that year her drawings amounted to $2,540.
Note: Calculations must be shown.
4. S. Agnew has lost his record of sales, and you will have to deduce the sales figure. The
summary of his bank account for the year ended 31 December 2006 is as follows.
Receipts from receivables
Extra capital introduced
$
67,595
3,000
Balance 1 Jan 2006
Suppliers for goods
Motor expenses
Rent and rates
General expenses
Fixtures bought
Drawings
_____ Balance 31 Dec 2006
70,595
LECTURE NOTES
$
2,059
49,382
4,624
3,728
846
3,500
1,364
5,092
70,595
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
A cash loan of $500 had been received on 1 July 2006. Interest is to be paid on this at the rate of 16%
per annum. Cash payments were as follows:
$
6,070
406
707
Drawings
Suppliers
General expenses
Cash received from receivables was $6,630
Motor vans owned by the firm had cost $8,000 in January 2004, and depreciation should be
written off at 25% using the reducing balance method. Fixtures costing $2,000 had been bought
in January 2003 and depreciation is being written off at the rate of 10%, using the straight-line
method.
The following information is also given.
31.12.2005
$
Inventory
10,500
Cash in hand
165
Trade Payables
6,238
Trade Receivables
16,840
Motor expenses owing
123
Rent paid in advance
115
Rent owing
-
(a)
(b)
(c)
(d)
31.12.2006
$
11,370
112
4,187
19,385
238
230
You are required to:
draw up the receivables and payables control accounts;
draw up the cash account summary for the year;
calculate opening capital as on 1 January 2006;
prepare the Income Statement for the year ended 31 December 2006 and a Statement of
Financial Position as at that date.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Partnership
Lecture Notes 1
Definition
The Partnership Act of 1890 defines partnership as:
‘The relationship which subsists between persons carrying on a business in common with a view to
profit.’
Thus:
(a) Partnership is a relationship. In fact it is a relationship requiring the utmost trust and
cooperation between the partners.
(b) Partnership is a business relationship. It is concerned with two or more people who jointly own
and a manage a business
(c) The objective of the partnership is to make a profit which has to be shared in some ways by the
partners.
The Need for Partnerships
There are various reasons for multiple ownership:



The capital required is more than one person can provide
The experience or ability required to manage the business cannot be found in one person
alone.
Many people want to share management instead of doing everything on their own.
NOTE: There are two types of multiple ownership: Partnerships and Limited Companies.
Nature of a Partnership
A partnership has the following characteristics




It is formed to make profits.
It must obey the law given in the Partnership Act of the Caribbean Commonwealth.
The partnership laws in each of the Caribbean countries are very similar to one another. The
differences are minor ones and may be ignored. The basic law from which the various
countries’ laws have evolved is the UK partnership Act 1890.
Normally there can be a minimum of 2 partners and a maximum of 20 partners.
Exceptions are banks, where there cannot be more than 10 persons.
LECTURE NOTES
UNIVERSITY OF GUYANA

ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Each partner (except for limited partners) must pay his or her share of any debt that the
partnership cannot pay. If necessary, partners can be forced to sell all their private possessions
to pay their share of the debts. This is what is meant by unlimited liability.
Limited Partners
Limited partners are not liable for the debts of the company and have the following characteristics:
 Their liability for the debts of the partnership is limited to the capital they have put in. They can
lose that capital, but they cannot be asked for any more money to pay the debts.
 They are not allowed to take part in the management of the partnership business.
 Not all the partners in a partnership can be limited partners: there must be at least one with
unlimited liability.
Partnership Agreements
Agreements in writing are not necessary. However, it is better if a proper written agreement is drawn
up by a lawyer or accountant. Where there is a proper written agreement there will be fewer
problems between partners, and less confusion about what has been agreed.
Contents of Partnership Agreements
The essence of a partnership is the agreement. Partners must agree about all aspects of the conduct
of the business and of the relationship between the partners. Some of the aspects which must be
covered by the agreement are:
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
Who the partners are.
How much each should contribute to the partnership capital.
When the partnership should commence.
How long the partnership should last.
How profits should be shared.
How much each partner may draw from the business.
Hours of work, holidays etc.
What happens if a partner dies, retires, becomes bankrupt, medically incapable or insane.
The extent to which partners can engage in other business activities.
Commercial matters – products, premises, rate of expansion, employment policy etc.
The usual accounting contents are:
 The capital to be contributed by each partner
 The ratio in which profits (or losses) are to be shared
 The rate of interest, if any, to be paid on capital before the profits are shared
 The rate of interest, if any, to be charged on partners’ drawings
LECTURE NOTES
UNIVERSITY OF GUYANA



ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Salaries to be paid to partners
Arrangements for the admission of new partners
Procedures to be carried out when a partner retires or dies.
The agreement may be a formal one – a deed drawn up by a solicitor and signed by all the partners –
or it may be written less formally, perhaps in the form of the exchange of letters or minutes of a
meeting or it may merely be the conduct of the parties. The assumption behind the latter is that the
agreement is what the partners do. For example, if the written partnership agreement says that the
partners may take two weeks holiday each a year but they actually take four weeks each, then their
agreement is not what the written agreement says but what they do. In practice, failure to agree in
advance on some aspect of the partnership affairs may lead to acrimony and even collapse of the
partnership.
If There is no Partnership Agreement
A special section of the Partnership Act of 1890 covers this situation. If there is no partnership
agreement, written or otherwise, the following provisions will apply:




Profits and losses will be shared equally
There is to be no interest on capital
No interest is to be charged on drawings
Salaries are not allowed
The Law
The General Law was codified in the Partnership Act 1890 and that relations between partners are
governed by their partnership agreement whether this be expressed, or implied by the conduct of the
parties. The number of partners in a partnership permissible in law is restricted to 20 except for
certain professional partnerships – accountants, doctors, solicitors, chartered loss adjusters etc.
Section 24 of the Partnership Act of 1890 states how profits are to be shared in the absence of an
agreement.
Profit Sharing
Partners can share the profits of their business in any way they like. Many partnerships share profits in
ways which reflect the differing contributions made by the partners to business, for example:
(a) Capital Invested: For example suppose the capitals were Allen $2,000 and Beet $1,000. Many
people would share the profits in the ratio of two-thirds, one-thirds, even though the work to
be done by each partner is similar. Consider too the capital ratio sharing of profits when one
partner has put in $99,000 and the other $1,000 as capital. In this case, one partner would get
99/100ths while the other would get only 1/100th!
To overcome the difficulty of compensating for the investment of extra capital the concept of
Interest on Capital was devised.
(b) Time spent on business.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
(c) Expertise or experience.
(d) Seniority
Some profit sharing arrangements are complex. For example, in the partnership of Dick, Eddie and
Fred they agreed that:
(a) Each should have a part of the profit equivalent to 10% of their capital at the beginning of the
year. This reflects the different amounts of capital each has tied up in the partnership business.
(b) Dick should have $7,000 of the profit to reflect the fact that he alone works full time on the
business and thus foregoes the salary he could have earned elsewhere.
(c) Eddie should have a share of the profit equal to 2% of the sales to reflect the special expertise
he has in obtaining customers.
(d) Any remaining profit should be shared equally.
Interest on Capital
If the work to be done by each partner is of equal value but the capital contributed is unequal, it is
reasonable to grant interest on the partners’ capitals. This interest is treated as a deduction prior to
the calculation of profits and their distribution according to the profit-sharing ratio.
The rate of interest is a matter of agreement between the partners, but it should equal the return they
would have received if they had invested the capital elsewhere.
Taking Allen and Beet’s firm again, but sharing the profits equally after charging 5% per annum interest
on capital, the division of profits are shown below. Allen has received $250 more than Beet, this being
adequate return (in the partners’ estimation) for her having invested an extra $1,000 in the firm for
five years.
Years
Net Profits
Interest on Capitals
Allen
Beet
Remainder Shared
Allen ½
Beet ½
Summary
Interest on Capital
Balance of profits
1
$
1,800
2
$
2400
3
$
3,000
4
$
3,000
5
$
3,600
100
50
100
50
100
50
100
50
100
50
= 500
= 250
825
825
1,125
1,125
1,425
1,425
1,425
1,425
1,725
1,725
= 6525
= 6525
Allen
$
500
6,525
7,025
Beet
$
250
6,525
6,775
LECTURE NOTES
Total
$
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Interest on Drawings
It is obviously in the best interests of the firm if cash is withdrawn from the firm by the partners in
accordance with the two basic principles of as little as possible and as late as possible. The more cash
that is left in the firm, the more expansion can be financed, the greater the economics of having ample
cash to take advantage of bargains and not missing out on cash discounts, and so on. To deter the
partners from taking out cash unnecessarily, the concept can be used of charging the partners interest
on each withdrawal, calculated from the date of withdrawal to the end of the financial year. The
amount charged to them helps to swell the profits divisible between the partners. The rate of interest
should be sufficient to achieve this without being too harsh.
Suppose Allen and Beet have decided to charge interest on drawings at 5% per annum, and that their year-end
was December 31. The Drawings made are shown below:
Allen
Interest
Drawings
1 January
1 March
1 May
1 July
1 October
$
100
240
120
240
80
Beet
Interest
Drawings
1 January
1 August
1 December
$100 x 5% x 12 months
$240 x 5% x 10 months
$120 x 5% x 8 months
$240 x 5% x 6 months
$80 x 5% x 3 months
Interest Charged to Allen
$
5
10
4
6
1
26
$
60
480
240
$60 x 5% x 12 months
$480 x 5% x 5 months
$240 x 5% x 1 month
Interest Charged to Beet
$
3
10
1
14
Salaries to Partners
One partner may have more responsibility or tasks than the others. As a reward for this, rather than
change the profit and loss-sharing ratio, he or she may have their salary deducted before sharing the
balance of profits.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Exercise
Taylor and Clarke have been in partnership for one year, sharing profits and losses in the ratio of threefifths to Taylor and two-fifths to Clarke. They are entitled to 5% per annum interest on capital, Taylor
having $2,000 capital and Clarke $6,000. Clarke is to have a salary of $500. They charge interest on
drawings, Taylor being charged $50 and Clarke $100. The net profit, before any distributions to the
partners, amounted to $5,000 for the year ended December 31, 2007.
Taylor and Clarke’s Distribution of Profits
$
Net Profit
Add Charges for interest on drawings:
Taylor
Clarke
$
$
5,000
50
100
150
5,150
Less
Clarke’s Salary
Interest on Capital:
Taylor
Clarke
500
100
300
400
Balance of profits
Shared
Taylor 3/5
Clarke 2/5
900
4,250
2,550
1,700
4,250
The $5,000 net profits have therefore been shared as follows:
Balance of profits
Interest on capital
Salary
Less Interest on drawings
Taylor Clarke
$
$
2,550 1,700
100
300
500
2,650 2,500
50
100
2,600 2,400
$5,000
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
The Final Accounts
If the sales, inventory and expenses of a partnership were exactly as those of a sole trader, then the
Income Statement would be identical to those prepared for the sole trader. However, a partnership
has an extra section shown under the Income Statement. This section is called the Appropriation
Account, and it is in this account that the distribution of profits is shown. The heading to the Income
Statement does not include the words ‘appropriation account’. It is purely an accounting custom not
to include it in the heading.
Taylor and Clarke
Income Statement for the year ended December 31, 2007
$
Sales
Less Cost of goods sold:
Purchases
Less Closing Inventory
Gross Profit
41,500
4,500
Less Expenses:
Pay
Rent and Rates
General expenses
Net Profit
Add Charges for interest on drawings:
Taylor
Clarke
Clarke’s Salary
Interest on Capital:
Taylor
Clarke
Balance of profits/Residual Profits
Shared
Taylor 3/5 ths
Clarke 2/5 ths
$
2,400
3,200
900
50
100
Less
$
48,500
37,000
11,500
6,500
5,000
150
5,150
500
100
300
400
2,550
1,700
900
4,250
4,250
With a sole trader, all of the profits belong to the sole trader, but in a partnership the profit is shared
among the partners. Consequently an additional account is required to show the appropriation of the
profit among the partners. The profit is shared in accordance with the agreement.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Capital Accounts
At the formation of a new partnership, the partners may agree to put into the partnership from their
private resources, cash and/or other assets to an agreed value. The amount of such resources put in
by a partner is his capital. Usually the partners agree that no partner will withdraw resources from the
partnership in such a way that the capital is reduced. A partner’s capital account will only change by
agreement or on the occurrence of events such as a change in the profit sharing ratio or on the death
or the retirement of a partner, or the admission of a new partner.
Each Partner will want to know exactly the value of his or her holding in the firm. We can say that this
consists of:
 The original capital put into the firm by the partner
 His or her share of the profits, interest on capital (if any), salary (if any), less interest on
drawings (if any) and drawings themselves – in other words, this is really the amount of
undrawn profits.
Current Accounts
If a profit is made by a partnership, it means that the net assets of the partnership have increased by
the amount of the profit. Each partner’s share of the profit is credited to his current account. The
balance standing to the credit of a partner’s current account represents the maximum amount that the
partner can withdraw from the partnership assets. Thus a partner can only make drawings up to the
amount of his accumulated share of profits. The current account represents undrawn profits.
Capital Accounts without Current Accounts
Many partnerships simply have capital accounts without partners’ current accounts. In these cases,
the capital account represents a mixture of capital subscribed and undrawn profits. There is therefore
no maximum put on partners’ drawings by the division between capital and current accounts and
restriction of another sort has to be agreed upon (Perhaps a weekly amount and an annual drawing
when profits have been calculated).
Now we could have an account for each partner which would contain both kinds of information. The
balance on this account would fluctuate each year as drawings very rarely exactly equal profits. This is
rather like a capital account in a sole trader’s business. Because the balance fluctuates, these are
called Fluctuating Capital Accounts.
On the other hand, we could keep the original capital figure in an account for each partner. These we
would keep at the same figure, and we would call these Fixed Capital Accounts. We would show the
share of the profits and interest on capital for each partner in separate accounts called Current
Accounts.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Assume that both Taylor and Clarke withdrew $2,000 from their business:
Fixed Capital Accounts plus Current Accounts
2007
Dec 31
Dec 31
Dec 31
2007
Dec 31
Dec 31
Dec 31
Cash: drawings
Profit and loss
Appropriation account:
Interest on Drawings
Balance c/d
Cash: drawings
Profit and loss
Appropriation account:
Interest on Drawings
Balance c/d
Taylor: Capital
2007
Jan 1
Bank (Cash introduced)
$
2,000
Clarke: Capital
2007
Jan 1
Bank (Cash introduced)
$
6,000
Taylor: Current Account
$
2007
2,000 Dec 31 Profit and loss
appropriation account:
Interest on Capital
50
Share of profits
600
2,650
2008
Jan 1
Balance b/d
Clarke: Current Account
$
2007
2,000 Dec 31 Profit and loss
appropriation account:
Interest on Capital
100
Share of profits
400
Salary
2,500
2008
Jan 1
Balance b/d
LECTURE NOTES
$
100
2,550
2,650
600
$
300
1,700
500
2,500
400
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Fluctuating Capital Accounts
2007
Dec 31
Dec 31
Dec 31
Taylor: Capital Account
$
2007
2,000 Jan 1
Bank
Dec 31 Profit and loss
appropriation account:
50
Interest on Capital
2,600
Share of profits
4,650
Cash: drawings
Profit and loss
Appropriation account:
Interest on Drawings
Balance c/d
2008
Jan 1
2007
Dec 31
Dec 31
Dec 31
$
2,000
100
2,550
4,650
Balance b/d
2,600
Clarke: Capital Account
$
2007
2,000 Jan 1
Bank
Dec 31 Profit and loss
appropriation account:
100
Interest on Capital
6,400
Share of profits
Salary
8,500
2008
Jan 1
Balance b/d
Cash: drawings
Profit and loss
Appropriation account:
Interest on Drawings
Balance c/d
$
6,000
300
1,700
500
8,500
6,400
Columnar Form of the Fluctuating Capital Account
Capital Accounts
Taylor Clarke
2007
Dec 31
Dec 31
Dec 31
Cash: drawings
Profit and loss
Appropriation account:
Interest on Drawings
Balance c/d
$
2,000
$
2007
2,000 Jan 1
Dec 31
50
2,600
100
6,400
4,650
8,500
Bank
Profit and loss
appropriation account:
Interest on Capital
Share of profits
Salary
Taylor Clarke
$
2,000
$
6,000
100
2,550
300
1,700
500
8,500
4,650
2008
Jan 1
Balance b/d
LECTURE NOTES
2,600
6,400
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
The Preference of Fixed Capital Accounts
The keeping of fixed capital accounts plus current accounts is considered preferable to fluctuating
capital accounts. When partners are taking out greater amounts than the share of the profits they are
entitled to, this is shown by a debit balance on the current account and so acts as a warning.
Statement of Financial Position
The statement of financial position formats of a partnership are the same as for sole traders. The
difference is that instead of a single capital account for the proprietor, there are several accounts (and
perhaps current accounts), one for each partner. In simple cases, the full accounts can be given,
showing separately, opening balance, share of profit, drawings closing balance. But in more complex
cases, the detail is usually put in a separate schedule and only the final balances put on the statement
of financial position.
Fixed Capital Statement of Financial Position (Extract)
Capital
$
2,000
6,000
8,000
Taylor
Clarke
Current Accounts
Taylor
$
Clarke
$
100
Interest on Capital
Salary
Share of profits
$
$
300
500
1,700
2,500
2,550
2,650
Less Drawings
Less Interest on drawings
2,000
50
2,050
600
2,000
100
2,100
400 1,000
9,000
Fluctuating Capital Statement of Financial Position (Extract)
Capital
Taylor
$
Cash Introduced
Interest on Capital
Salary
Share of profits
Less Drawings
Less Interest on drawings
Clarke
$
2,000
100
$
2,550
4,650
2,000
50
2,050
2,600
2,000
100
LECTURE NOTES
$
6,000
300
500
1,700
8,500
$
2,100
6,400 9,000
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
If one of the current accounts had finished in debit, for instance if the current account of Clarke had finished up
as $400 debit, the abbreviation Dr. would appear and the balances would appear net in the totals column:
Closing balances
Taylor
Clarke
$
600
$
400 Dr.
$
200
If the net figure turned out to be a debit figure, then this would be deducted from the total of the capital
accounts.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Partnership
Worksheet 1
1. For the year ended 31 December 2006, their capital accounts remained fixed at the following
amounts:
$
Stephens
6,000
Owen
4,000
Jones
2,000
They have agreed to give each other 10% interest per annum on their capital accounts.
In addition to the above, partnership salaries of $3,000 for Owen and $1,000 for Jones are to be
charged.
The net profit of the partnership, before taking any of the above into account, was $25,200.
You are required to draw up the appropriation account of the partnership for the year ended 31
December 2006.
2. Draw up a income statement appropriation account for the year ended 31 December 2007 and
statement of financial position extracts at that date, from the following:
1.
2.
3.
4.
5.
6.
7.
8.
Net profit $30,350
Interest to be charged on capitals: Williams, $2,000; Powell, $1,500; Howe, $900.
Interest to be charged on drawings: Williams, $240; Powell, $180; Howe, $130.
Salaries to be credited: Powell, $2,000; Howe, $3,500.
Profits to be shared: Williams, 50%; Powell, 30%; Howe 20%.
Current accounts: Williams $1,860; Powell $946; Howe, $717.
Capital accounts: Williams, $40,000; Powell $30,000; Howe, $18,000.
Drawings: Williams, $9,200; Powell, $7,100; Howe, $6,900.
3. Mendez and Marshall are in partnership, sharing profits and losses equally. The following is
their trial balance as at 30 June 2006.
Buildings at cost
Fixtures at cost
Provision for depreciation: fixtures
Trade Receivables
Trade Payables
LECTURE NOTES
Dr.
$
50,000
11,000
Cr.
$
3,300
16,243
11,150
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
Cash at bank
Inventory at 30 June 2005
Sales
Purchases
Carriage outwards
Discounts allowed
Loan interest: Khan
Office expenses
Pay
Bad debts
Provision for bad debts
Loan from J. Khan
Capital:
Mendez
Marshall
Current accounts:
Mendez
Marshall
Drawings:
Mendez
Marshall
TROY J. WISHART
677
41,979
123,650
85,416
1,288
115
4,000
2,416
18,917
503
400
40,000
35,000
29,500
1,306
298
6,400
5,650
______
244,604
=======
_______
244,604
=======
Prepare a income statement and appropriation account for the year ended 30 June 2006, and a
statement of financial position as at that date.
1. Inventory, 30 June 2006: $56,340.
2. Expense to be accrued: office expenses, $96; pay, $200.
3. Depreciate fixtures 10% on reducing balance basis. Depreciate buildings $1,000.
4. Reduce provision for bad debts to $320.
5. Partnership salary: $800 to Mendez. Not yet entered.
6. Interest on drawings: Mendez, $180, Marshall, $120.
7. Interest on capital account balance at 10%.
4. Q and P have similar businesses and decide to amalgamate and form a partnership. On 1
January 2005 they had the following assets and liabilities:
Equipment
Trade Receivables
Inventory
Premises
Motor van
Trade Payables
Q
$
7,000
2,100
12,000
15,000
1,970
P
$
8,000
3,900
9,000
7,200
2,040
LECTURE NOTES
UNIVERSITY OF GUYANA
Prepaid expenses
Expenses owing
ACT 220 FINANCIAL ACCOUNTING 2
300
430
TROY J. WISHART
230
790
From 1 January 2005, they agreed that:
1. profits and losses would be shared equally;
2. interest on capital at 10% would be allowed;
3. P was to get a salary of $2,000 per annum;
4. Interest on drawings at 10% per annum would be charged; for 2005 this amounted
to $120 for Q and $200 for P.
For the year to 31 December 2005, a net profit of $23,680 was made. Q’s drawings were
$5,200 and P’s, $8,400.
You are required to:
(a) ascertain opening capitals;
(b) draw up a profit and loss appropriation account for the year ended 31 December
2005;
(c) draw up capital accounts as they would be shown in the statement of financial
position as at 31 December 2005, assuming fluctuating capital accounts are to be
used.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Partnership
Lecture Notes 2 – Goodwill and Changes in Partnership
Goodwill – Definition
The excess amount that has to be paid to acquire a part or the whole of a business as a going
concern over and above the value of the assets owned by the business.
Suppose you have been in business for some years and you want to sell up. How much would you ask
as the total sale price of the business? You decide to list how much you could get for each asset if sold
separately. This list might be as follows:
$
Buildings
225,000
Machinery
75,000
Trade Receivable
60,000
Inventory
40,000
400,000
Instead, however, you sell the whole of the business as a going concerning to Ms Lee for $450,000.
She has therefore paid $50,000 more than the total for all the assets. This extra payment of $50,000 is
for what is called Goodwill. Ms. Lee has paid this because she wanted to take over the business as a
going concern. Thus,
Purchased goodwill = Total price – Value of Identifiable Assets
Note: A business that is a Going Concern is based on the concept that a business will continue for a
long time.
Goodwill has been judicially described as ‘the probability that the customers of a business will
continue to patronize the business on a change of ownership’. Goodwill can be personal to
proprietor, in which case customers will cease to patronize the business on a change of ownership.
Goodwill like any other scarce commodity is worth what a buyer will pay a willing seller. The value, or
price if it is to be sold, is normally reached by negotiation or in cases of dispute by independent
arbitration.
Reasons for Payment of Goodwill
In buying an existing business which has been established for some time, there may be quite a few
possible advantages. For example:




There is a large number of regular customers who will continue to deal with the business under
a new owner
The business has a good reputation
It has efficient and reliable employees
It is in a good location
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
 It has good contacts with suppliers
These advantages are not available to completely new business and as such, people will pay an extra
amount for goodwill when buying an existing business. However, Goodwill will only exist in a business
if it has had a good reputation. If the business has a bad reputation, an inefficient workforce and
other negative factors, no one will want to pay an extra amount for goodwill.
Methods of Calculating of Goodwill
Various methods are used to help buyer and seller come to an agreed figure. The calculations give
buyer and seller a figure with which to begin discussions of the value of the business. Very often each
industry has its own customary way of calculating goodwill.
Average Sales Method
In many retail businesses the yearly sales for the past few years are multiplied by an agreed figure.
For instance, suppose that it is agreed that the goodwill should be three times the average yearly sales
for the last two years. Then the calculations maybe:
Year
2005
2006
Total
Average annual sales = $300,000 ÷ 2 = $150,000
Goodwill = 3 × $150,000 = $450,000
Sales
$
140,000
160,000
300,000
Annual Fees Method
Professional firms such as accountants or lawyers, often use a method based on gross annual income
of fees, before charging expenses. For instance, a firm of accountants is selling its business. It is asking
for goodwill that is two and a half times the average annual fees received for the last two years.
Year
2005
2006
Total
Average annual fees = $400,000 ÷ 2 = $200,000
Goodwill = 2.5 × $200,000 = $500,000
Annual Fees
$
180,000
220,000
400,000
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Average Net Annual Profits Method
The average net profit for a number of years is multiplied by a stated amount. Suppose goodwill is
taken four times the average net annual profits for the past three years:
Year
Annual Fees
$
2004
62,000
2005
69,000
2006
79,000
Total
210,000
Average net annual profits = $210,000 ÷ 3 = $70,000
Goodwill = 4 × $70,000 = $280,000
Super Profits Method
Super profits are what are left of the net profit after allowances have been made for the services of
the proprietor and the use of his or her capital. It is calculated as follows:
$
Annual net Profits
Less Remuneration proprietor would have
earned for similar work elsewhere
Interest that would have been earned
If capital had been invested elsewhere
Annual super profits
$
80,000
20,000
10,000
30,000
50,000
The annual super profits are then multiplied by a number agreed by the seller and purchaser of the
business.
Changes in Partnership
Overtime a partnership can experience several changes that affect how accounting for the partnership’s
operations is done. Some of those changes maybe one of the following
a) A decision to change in profit/loss ratio.
b) Introduction of a new partner
c) Retirement of a partner.
Most of these changes involve the valuation of Goodwill.
When a change occurs in a partnership which is a going concern such that goodwill has value then the following
procedures are required:
a) Agree on the value of goodwill
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
b) Write up the goodwill account, by debiting goodwill and crediting the pre-change partners in the prechange profit/loss sharing ratio.
c) Write down the goodwill to nil, by crediting goodwill account and debiting the post-change partners in
the post-change profit/loss sharing ratio.
d) Assets other than goodwill are sometimes involved and are treated in the same way.
Change in Profit Sharing Ratio
Partnerships for some reason or another would often decide to change their profit sharing ratio, either to
accommodate a partner’s lesser or greater involvement or contribution to the partnership’s firm. As a result of
this change in their profit sharing ratio adjustments have to be made to the partnerships share in the goodwill
and fixed assets to compensate the partners loosing and charge partners gaining.
Example
The partners, Graham and Keith of Truckbits, share profits equally and the partnership statement of
financial position at June 30, 2004 was:
$
$
Non-Current Assets
35,000
Capital: Graham
30,000
Current Assets
28,000
Keith
18,500
______
Current Liabilities
14,500
63,000
63,000
The partners agreed that as Graham wished to take a smaller part in the partnership business, the
profit sharing ratio should change to 2:3 with a salary of $5,000 a year to Keith. For the purpose of the
change only, goodwill was agreed at a value of $30,000 and non-current assets at a value of $47,000.
These changes in value were not to be incorporated in the books.
Answer
Graham (a)
Keith (a)
Goodwill Account
$
15,000 Graham (b)
15,000 Keith (b)
30,000
Balance b/f
Graham (a)
Keith (a)
Non-current Assets
$
35,000 Graham (b)
6,000 Keith (b)
6,000 Balance c/f
47,000
LECTURE NOTES
$
12,000
18,000
30,000
$
4,800
7,200
35,000
47,000
UNIVERSITY OF GUYANA
Goodwill (b)
Non-current Assets (b)
Balance c/f
ACT 220 FINANCIAL ACCOUNTING 2
Graham
$
12,000
4,800
34,200
51,000
Capital Accounts
Keith
$
18,000 Balance b/f
7,200 Goodwill (a)
14,300 Non-currents Assets (a)
39,500
TROY J. WISHART
Graham
30,000
15,000
6,000
Keith
$
18,500
15,000
6,000
51,000
39,500
Notes:
a) Goodwill and non-current assets are written up to their agreed values ($30,000 and $47,000) by credits
to the partners’ accounts in the old profit sharing ratio (equal shares).
b) Goodwill and non-current assets are written down to their continuing book values (nil and $35,000) by
debits to the partners’ accounts in the new profit sharing ratios (2:3).
c) The salary part of the profit sharing formula is irrelevant for this purpose.
Admission of a New Partner
New partners may be admitted to a partnership for one of three reasons:
1. As an additional partner, either because the firm has grown or because someone is needed
who has different skills to those of the existing partners;
2. To replace a partner who is leaving the firm: this might be because of the retirement or death
of a partner
3. To bring in additional capital. The capital to be brought into a business by a new partner is
dependent on the agreement drawn up between the old partners and the new partners.
Goodwill on Admission of New Partners
A new partner will be entitled to a share in the profits, and normally, will also be entitled to the same
share in goodwill. It is expected that the new partner will be charged for taking over that share of
the goodwill. However, the true value of goodwill can be established only when the business is sold,
but for various reasons of fairness between partners it is valued the best way possible when there is no
imminent sale of the business.
Calculation of Goodwill Adjustments
The procedure for charging a new partner for taking over a share of the goodwill is as follows:
1. Show the value of goodwill divided between the original partners in the old profit and losssharing ratios.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
2. Then show the value of goodwill divided between the partners in the new partnership in the
new profit- and loss-sharing ratio.
3. Goodwill gain shown: charge partners for the gain.
Goodwill loss shown: give partners an allowance for their losses.
Example
A and B are in partnership, sharing profits and losses equally. C is admitted as a new partner. The
three partners will share profits and losses one-third each. Total goodwill is valued at $60,000.
Partners
A
Stage 1
Stage 2
Old
New
Share of
Share of
profit
profit
goodwill
goodwill
Shares
shares
$
$
½
30,000
1/3
20,000
Stage 3
Gained
or loss
To compensate
for loss
To charge
for gain
$
10,000 Cr. A Capital
(Lost)
B
C
½
30,000
60,000
1/3
20,000
1/3
20,000
10,000 Cr. B Capital
(Lost)
20,000
(Gained)
Dr. C Capital
60,000
This means that A and B need to have their capitals increased by $10,000 each. C needs his capital
reducing by $20,000. You may well wonder why A and B should have their capitals increased by
$10,000 each, i.e. receive a credit $10,000 in each of their capital accounts. They have each given up
part of their ownership of an asset, in this case goodwill, to the new partner C. C could be charged for
this, which is done by debiting his capital account by $20,000. As it is A and B that have passed over to
him part of their ownership, the corresponding credits should be made in their capital accounts for
$10,000 each. If this were not done they would have given up their shares of the goodwill for nothing.
Example 2
D and E are in partnership sharing profits ½ each. A new partner F is admitted. Profits will now be shared D
one-fifth 1/5, and E and F two-fifths each. D and E have therefore not kept their shares equal to each other.
Goodwill is valued at $60,000. As a result of the admission of F, D’s capital will increase by $18,000; E’s capital is
to be increased by $6,000; and F needs his capital reduced by $24,000.
LECTURE NOTES
UNIVERSITY OF GUYANA
Partners
D
E
ACT 220 FINANCIAL ACCOUNTING 2
Stage 1
Stage 2
Old
New
Share of
Share of
profit
profit
goodwill
goodwill
shares
Shares
$
$
30,000
1/5
12,000
½
½
F
30,000
-
2/5
24,000
2/5
24,000
60,000
TROY J. WISHART
Stage 3
Gained
or loss
To compensate
for loss
To charge
for gain
$
18,000 Cr. D Capital
(Lost)
6,000 Cr. E Capital
(Lost)
24,000
Dr. F Capital
(Gained)
60,000
Accounting Entries for Goodwill Adjustments
These depend on how the partners wish to arrange the adjustment. Three methods are usually used:
1) Private Arrangement – Cash is paid by the new partner privately to the old partners for his or her
share of the goodwill. No goodwill account is opened. Therefore, in the above example F would
therefore give $24,000 in cash: $18,000 to D and $6,000 to E. D and E would bank these amounts
in their private bank accounts. No entry would be made for this in the accounts of the partnership.
2) Formal Arrangement – Cash is paid by the new partner into the business bank account for his or
her share of the goodwill. No goodwill account is opened. Assume that the capital balances before
F was admitted were D $50,000 and E $50,000, and F was to pay in $50,000 as capital plus $24,000
for goodwill. The entries would be as follows:
Capital Accounts
Adjustments for gain of
goodwill
D
E
F
D
E
F
$
$
$
$
50,000
$
50,000
$
Balances b/f
24,000
Cash for capital
Balance c/d
50,000
68,000 56,000 50,000
Adjustments for loss of
goodwill
18,000
Cash for goodwill
68,000 56,000 74,000
6,000
24,000
68,000
56,000 74,000
3) No Arrangement – A goodwill account is opened. No extra cash is to be paid by the new partner
for the goodwill. The opening capitals were D$50,000; E $50,000; F paid in $50,000 as capital. The
action required is as follows:
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
a) Debit goodwill account with total value of goodwill. Credit capitals of old partners with their
shares of goodwill in old profit ratios.
b) Debit adjustments gains to partners’ capitals. Credit adjustment losses to partners’ capital.
Goodwill
$
Value Divided:
D Capital
E Capital
$
30,000
30,000 Balance c/d
60,000
60,000
60,000
Capital Accounts
Adjustments for gain of
goodwill
D
E
F
$
$
$
D
Balances b/f
E
$
$
50,000 50,000
$
24,000
Cash for capital
Balance c/d
F
50,000
98,000 86,000 26,000
Goodwill adjustments
30,000 30,000
Adjustments for loss of
goodwill
18,000
98,000 86,000 50,000
98,000
6,000
86,000 50,000
Premiums for Goodwill
The amounts paid in by the new partners, or charged to them, for goodwill is often known as a
Premium.
Modern Accounting Theory for Goodwill
Modern Accounting theory for goodwill requires that Goodwill should only be created to facilitate a
change in the partnership. After this change has been done, goodwill should be written down to nil
since goodwill is a subjective asset that inflates the statement of financial position. Accounting theory
requires that the true picture of the firm’s financial position be reported.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Example
Jonathan and Diane are in partnership sharing profits equally and with a statement of financial position
as at July 31, 2005.
$
100,000
______
100,000
Net Assets
Capital: Johnaton
Diane
$
60,000
40,000
100,000
On August 1, 2005, Tina was admitted to the partnership and brought in $30,000 cash. Profit sharing
was to be in equal shares. It was agreed that goodwill was worth $24,000 and that no goodwill
account was to be maintained in the books.
Goodwill Account
$
12,000 Johnaton
12,000 Diane
Tina
24,000
Johnaton
Diane
Goodwill
Balance c/f
Johnaton
$
8,000
64,000
72,000
Capital Accounts
Diane
Tina
$
$
8,000
8,000 Balance b/f
44,000
22,000 Goodwill
Cash
52,000
30,000
$
8,000
8,000
8,000
24,000
Johnaton
$
60,000
12,000
Diane
$
40,000
12,000
Tina
$
30,000
72,000
52,000
30,000
Retirement of Partnership
In theory, the retirement of a partner from the partnership involves the dissolution of the partnership
and the setting up of a new partnership of the non-retiring partners from the old partnership. In
practice the assets and liabilities of the partnership are usually carried through to the partnership and
the books continued.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
The steps required on the retirement of a partner are:
1. Determine the value of goodwill
2. Write up the value of goodwill as:
Dr
Goodwill
Cr
Partners in their profit sharing ratio
3. Charge any assets taken by the retiring partner to his account.
4. Making any required adjustments to the value of any assets or liabilities with corresponding
entries in the capital accounts of any profits/losses in profit sharing ratio.
5. Write down value of goodwill to nil by:
Dr
Capital accounts of remaining partners
Cr
Goodwill
In the new profit sharing ratio
6. Re-titling the capital (together with current account) of the retiring partner as a loan to the new
partnership.
Example
Bill, Moon and Hartland are in partnership sharing profits equally. On December 31, 1991 their
Statement of Financial Position showed:
$
Plant and Vehicles
Inventory
Trade Receivables
Cash at Bank
28,000
14,000
21,700
6,800
70,500
$
Capital: Bill
Moon
Hartland
Current Liabilities
31,100
17,000
11,900
10,500
70,500
On January 1, 1992, Bill retired and it was agreed that, in accordance with the partnership agreement:



Goodwill was valued at $34,000
Bill should take a car (written down value $2,800) at a valuation of $4,000.
Bill should take $5,000 immediately and leave the balance on loan bearing interest at 10%.
Repayment would be in two installments at the ends of 1992 and 1993.
The new profit sharing ratio between the remaining partners was to remain in equal shares.
Show:
a) The capital accounts and loan account in the books of the old partnership;
b) The Statement of Financial Position of the new partnership after the retirement.
Answer
a) Capital and loan accounts in the books of the old partnership.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
We will begin with an account to show the realization of the car which is taken by Bill:
Realization Account
$
2,800 Transfer to Bill
Car at Book value
Profit on realization
Bill
Moon
Hartland
Car withdrawn
Cash
Transfer Loan
Balance c/f
$
4,000
400
400
400
4,000
Bill
$
4,000
5,000
22,500
31,500
4,000
Capital Accounts
Moon Hartland
$
$
Balance b/f
Profit
Bill
$
31,100
400
Moon Hartland
$
$
17,000
11,900
400
400
17,400
17,400
31,500
17,400
12,300
12,300
b) Statement of Financial Position of the new partnership:
$
Plant and Vehicles
25,200
Capital: Moon
Inventory
14,000
Hartland
Trade Receivables
21,700
Loan Bill
Cash at Bank
1,800
Current Liabilities
62,700
LECTURE NOTES
$
17,400
12,300
22,500
10,500
62,700
12,300
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Partnership
Worksheet 2 – Goodwill and Changes in Partnership
1. June Graves and Cyril Regis want you to value the goodwill of their business, which they are
going to sell. You advise them that for their kind of business the ‘average sales method’ is
appropriate.
They say that they would agree to a valuation of four times the average yearly sales for the last
three years. The sales for the last three years have been: 2001, $240,000; 2002, $280,000;
2003, $275,000.
Show your calculation of the value of goodwill.
2. Scott and Simpson are selling their dental practice. They are asking a figure for goodwill which
is five times the average annual fees received for the last four years. The fees received were as
follows:
2001
2002
2003
2004
$
163,500
181,000
178,500
201,000
You are required to calculate the value of goodwill in accordance with the above figures.
3. James Barnes is selling his business. He has worked full-time in the business. Drawings, as they
should be, have been charged up to his capital account, not to the profit and loss account.
The cash that Barnes has invested in the business amounts to $200,000. If he had invested it
elsewhere he would have been able to get interest on it of 12%.
Barnes is a qualified engineer. If he had not been working in his own business he could have
been employed elsewhere for $60,000 a year.
His accountant advises him to value his goodwill at a figure equaling five years of ‘super profits’.
Required:
Calculate the value of goodwill at the figure stipulated by the accountant, given the above
information and the fact that his annual net profits amount to $110,000.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
4. Marshall and Russell are in partnership sharing profits and losses in the ratio of Marshall twothirds, Russell one-third. A new partner, Sangster, is introduced. Profits will be shared in the
ratio; Marshall one-half, Russell one-quarter, Sangster one-quarter. Just before the
introduction of Sangster, the statement of financial position had been as set out below.
Statement of Financial Position as at 31 December 2004
______________________________________________________________________________
$
$
Non-current Assets
Building
11,000
Current assets
Inventory
Trade Receivables
Bank
6,000
2,000
1,000
9,000
20,000
Capital and Liabilities:
Marshall
Russell
10,000
8,000
Current liabilities
Trade Payables
2,000
18,000
2,000
20,000
Show the different statement of financial positions given the different situations below after
Sangster is introduced on 1 January 2005.
(a) Sangster pays in a $8,000 cheque for capital, plus another $3,000 for his share of the
goodwill; or instead
(b) Sangster pays in an $8,000 cheque for capital; the $3,000 for goodwill is paid privately by
him to Marshall & Russell; or instead
(c) a goodwill account is to be opened of total estimated value $12,000. Sangster pays into the
business a cheque for $8,000 only in respect of capital.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Partnership
Lecture Notes 3 – Dissolution of Partnerships
The Dissolution of a partnership may be caused by many factors including:
a) Insolvency – the inability to continue because the partnership cannot meet its financial
obligations.
b) A decision of the partners not to continue, in order perhaps that each may go his own way.
c) The term of the partnership has expired, or the purpose for which the partnership was created
has been accomplished.
d) One partner has given notice to the other partner(s)
e) The partnership is now illegal e.g. one partner can no longer legally own a business
f) There is a court order, e.g. When one of the partners is certified as being of unsound mind or a
partner is unable to perform his part of the partnership contract.
g) The death or retirement of Partner.
The Realization Account
The dissolution of partnership involves the disposal (realization) of the assets. Inevitably the amounts
realized will differ from the book value and a profit or loss will result. The bookkeeping is:
a) Debit the realization account Credit the Asset Account with the book values of the assets being
realized.
b) Debit the Creditors A/c and Credit the realization account with the creditors who will be paid
off.
c) Debit the Cash Book and Credit the realization account with the proceeds of disposal of the
assets.
d) Debit the realization account and credit the cash book with the amount paid to creditors
e) Distribute the overall difference (profit or loss) among the partners in the profit sharing ratio
by debiting (in case of a profit) or crediting (in case of a loss) the realization and credit (in case
of a profit) or debit (in case of a loss) the partners’ capital a/c.
f) Complete the dissolution by paying to partners the balances on their capital/current accounts
by debiting the partners’ capital a/c and crediting the cash book.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Example
The statement of financial position of Vanessa and Julie at December 31, 2004 was as follows:
$
$
Non-Current Assets
Current Assets
Inventory
6,800
Trade Rec.
4,750
Cash at Bank 150
$
14,000
Capital: Vanessa
Julie
Current Accounts
Vanessa
Julie
Trade Payables
11,700
_____
25,700
10,000
9,000
1,900
1,700
3,100
25,700
The partnership was dissolved at January 31, 2005
a) The motor cars included in non-current assets were taken by the partners at agreed values as
Vanessa $2,000, Julie $3,000
b) The remainder of the non-current assets were sold for $12,000
c) The Inventory was sold at auction for $4,300
d) The trade receivables realized $4,600
e) The trade payables were paid off less a 5% discount
f) Expenses of realization were $250
g) The profit sharing formula is :10% interest on capital, Balance 3:2
Required: Show relevant accounts in the dissolution
Non-current Assets
Inventory
Trade Receivables
Trade Payables
Expenses
Profit on realization:
Vanessa
153
Julie
102
Realization Account
$
14,000 Car taken by Vanessa
6,800 Car Taken by Julie
4,750 Proceeds of sales of NC assets
2,945 Proceeds of sales of Inventory
250 Trade Receivables
Trade Payables
255
29,000
LECTURE NOTES
$
2,000
3,000
12,000
4,300
4,600
3,100
29,000
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Cash
$
Balance b/d
Proceeds from Non-current Assets
Proceeds from Inventory
Proceeds from Trade Receivables
150
12,000
4,300
4,600
21,050
Vanessa
$
2,000
10,053
Cars
Cash
12,053
$
2,945
250
Trade Payables
Expenses
Vanessa
10,053
Julie
7,802
Capital Accounts
Julie
$
3,000 Balance b/f
7,802 Current accounts b/f
Share of profit on
realization
10,802
17,855
21,050
Vanessa
$
10,000
1,900
Julie
$
9,000
1,700
153
102
12,053 10,802
Procedures for Dissolution of Partnership
a) Assets to be realized are debited to realization account.
b) The proceeds of the realization are credited to realization account and debited to cash or in the
case of the partners’ cars to the partners.
c) Trade Payables are usually put through the realization account if a profit or loss is involved, as
here.
d) There are often some expenses of realization
e) The profit/loss is shared in profit/loss sharing ratio – the interest on capital part of the formula
is irrelevant as no efflux ion of time is involved.
f) There is no need to show the account of the assets as they are simply (eg):
Inventory Account
$
$
Balance B/d
6,800
Transfer to Realization a/c
6,800
6,800
6,800
g) The capital and current accounts are put together in the dissolution of a partnership, since
their difference is no longer relevant. As a going concern capital accounts are not payable to
partners as they are permanent capital. Current accounts are payable to partners as they are
undrawn profits.
h) When all the assets have been realized and the creditors paid off, there are only three balances
left:
An Asset – cash
17,855
Two Liabilities: Vanessa
10,053
Julie
7,802
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
The asset matches the liabilities and can be used to pay them off, leaving no balances at all in
the double entry system.
Partners owing the Partnership at Dissolution
The case of Garner v Murray 1904 addresses the issue of when a partner finishing up in a debit (i.e.
owing the partnership money) and has no assets. In such, cases the remaining partners are debited
with the balance in accordance with the ratio of their partnership capital accounts. The rule is not
followed in all countries and in USA and elsewhere the loss would be debited in profit/loss sharing
ratio.
Example
Tom, Roger, and James are in partnership sharing profits equally. Their statement of financial position
at May 31, 2004 was:
$
Non-current Assets
Inventory
Trade Receivables
$
6,006
9,500
7,800
Capital: Tom
Roger
James
Trade Payables
Overdraft
_____
23,306
On June 1, 2004 the partnership was dissolved and the following happened:
1. The assets were sold to RPH Ltd for $20,000 only
2. The trade payables were settled for $6,103
3. James was declared bankrupt with no assets
Non-current Assets
Inventory
Trade Receivables
Cash paid to Creditors
Realization Account
$
6,006 RPH Ltd - Cash
9,500 Trade Payables
7,800 Loss on Realization: Tom
6,103
Roger
James
29,409
4,000
3,000
416
6,250
9,640
23,306
$
20,000
6,250
1,053
1,053
1,053
3,159
29,409
Cash
RPH Ltd
$
20,000 Balance b/f
Trade Payables
Tom
Roger
20,000
LECTURE NOTES
$
9,640
6,103
2,583
1,674
20,000
UNIVERSITY OF GUYANA
Share in Loss
Gv M
Cash
ACT 220 FINANCIAL ACCOUNTING 2
Tom
$
1,053
364
2,583
4,000
Capital Accounts
Roger
James
$
$
1,053
1,053 Balance b/f
273
Gv M
1,674
3,000
1,053
TROY J. WISHART
Tom
$
4,000
Roger
$
3,000
James
$
416
637
4,000
3,000
1,053
How to Work Problem
a) The first step is to open a realization account and transfer to it all the assets and the Trade
Payables.
b) The proceeds from the sale of assets $20,000 are credited to the realization account and
debited to cash.
c) Cash is credited and realization account debited with the payment to the Trade Payables.
d) The loss on realization is credited to realization account and debited in equal shares (the
profit/loss sharing ratio).
e) James’s account is in debit, meaning that he owes the partnership $637. As he is bankrupt he
cannot pay it so the debit balance has to be written off. This is done by debiting the remaining
partners in accordance with the rule in Garner v Murray 1904. Thus the amount is apportioned
in the ratio of their last agreed capital accounts ($4,000:$3,000).
f) The only remaining balances are cash Dr. $4,257 and the capital accounts of Tom Cr. $2,583 and
Roger $1,674. The books are cleared by payments to the partners.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Accounting for Limited Liability Companies
Lecture Notes
Definition
A Limited Liability Company is an organization owned by its shareholders, whose liability is limited to
their share capital.
The Need for limited Liability Companies
There are two reasons why there is a need for limited companies:
1. Expansion of the Company and the need for additional capital
2. Safe guarding owners’ private assets through Limited Liability
Types of Limited Companies
1. Private Companies
2. Public Companies
A Private Company:



Has a minimum membership of 2
Does not have more than 50 members (in Jamaica not more than 20), although there
also can be extra members who are working or have worked for the company.
Must ask people to buy company shares privately: it cannot do so in public.
Any company that does not follow the above is a public company. It must have at least 7 members
and can have as many members as it wants.
Characteristics of Limited Companies
These include:
1. Legal Personality: a company is regarded as having separate legal personality. It is an artificial
person that can own, make contracts, sue and be sued. The company is a separate entity
distinct from those who own it.
2. Perpetual Succession: As a company is a separate entity, its ownership can change without
changing the company itself.
3. Limited Liability: The owners of a company (known as its members or its shareholders) are not
liable for the debts of the company.
4. Stockholders are not Corporate Agents – A Limited Liability Company acts through its agents,
who are officers or managers of the company. Stockholders/shareholders who are not officers
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
or managers of the corporation do not have the power to bind the corporation to contracts.
This is referred to as lack of mutual agency. Instead stockholders participate in the affairs of
the company by voting in stockholder meetings.
5. Corporate Tax – Corporations are subject to the same property and payroll taxes as sole
proprietorships and partnerships. However, Limited Liability Companies are subject to
additional taxes not levied on either of these other forms of companies, that is, Corporation
Tax. This results in the income of a Limited Liability Company being taxed twice, first as income
of the company and second as personal income to shareholders when cash is distributed to
them as dividends. This is called double taxation.
6. Owners can Manage – All owners of a Limited Liability Company can be involved in managing
the business without losing liability protection.
7. Residual Equity –When a company has only one class of stock it is identified as common stock.
Common stock represents residual equity, meaning that creditors rank ahead of common
shareholders if the corporation is liquidated.
What Does Limited Liability mean?
Limited Liability means that the owners’ liability for a company’s debts in the event that the company
dissolves is equal to the amount of shares they have invested in the company. This means that they
will lose the monies they have invested for their shares in the company in the event that the
company’s assets cannot pay for its debt. However, shareholders who have partly paid for their shares
can be forced to pay the balance owing on the shares.
Thus limited liability is a major advantage of turning a business into a limited liability company.
However, in practice, banks will normally seek personal guarantees from shareholders before making
loans or granting an overdraft facility and so the advantage of limited liability is lost to a small owner
managed business. Another advantage is that the retirement or death of one of its members does not
necessitate dissolution and re-formation of the firm.
Disadvantages of Limited Liability Companies




Compliance with national legislation in having to prepare annual accounts and have them
audited, file annual returns and keep statutory books.
Greater administrative and financial burden.
Compliance with national accounting standards and /or IFRS
Any formation and registration costs
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Shareholders
Those persons who would have applied for, bought, and received shares from a Limited Company,
which ultimately means that they gain ownership in the company. A Shareholder usually receives a
share of the profits called Dividends.
Shares are usually issued to shareholders at par value or may exceed their par value. For example, a
company might issue 100,000 $1 shares at a price of $1.20 each. Subscribers will then pay a total of
$120,000. The issued share capital of the company would be shown in its accounts at par values,
$100,000; the excess of $20,000 is described not as share capital, but as Share Premium or Capital
paid-up in excess of par value.
Rights of Shareholders
When investors buy a company’s stock, they acquire all specific rights granted by the company’s
charter to shareholders. They also acquire general rights granted shareholders by the law. Common
Shareholders usually have the general right to:
1. Vote at shareholders meeting
2. Sell or otherwise dispose of their share
3. Purchase their proportional share of any common stock later issued by the corporation. This
right is called Preemptive Right. It protects shareholders proportionate interest in the
corporation. For example, a shareholder who owns 25% of a company’s common stock has the
first opportunity to buy 25% of any new common stock issued. This enables the stockholder to
maintain a 25% interest if desired.
4. Share equally with other common stockholders in any dividends. This means each common
share receives the same dividend.
5. Share equally in any assets remaining after creditors are paid when, and if, the company is
liquidated. This means each common share receives the same amount of remaining liquidated
assets.
6. Shareholders have the right to receive timely reports on the company’s financial position and
results of operations.
Share Capital
In preparing a statement of financial position the following is applicable:



Ordinary and preference share capital
Reserves
Loan Stock
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
The Capital of Limited Liability Companies
The proprietor’s capital in a limited Liability company consists of SHARE CAPITAL. When a company is
set up for the first time, it issues shares which are paid for by investors, who then become
shareholders of the company. Shares are denominated in units of 25 cents, 50 cents, $1 or whatever
seems appropriate. The ‘face value’ of the shares is called their par value (or sometimes the nominal
value).
Shares
Share is the division of capital of a limited company into parts.
There are two main types of shares:
A. Preference Shares – are shares which confer certain preferential rights on their holder. Preference
shares carry the right to a final dividend which is expressed as a percentage of their par value: e.g.
6% $1 preference share carries a right to annual dividend of 6c. Preference dividends; in other
words, if the managers of a company wish to pay a dividend (which they are not obliged to do) they
must pay any preference dividend first. Otherwise, no ordinary dividend maybe paid.
The Rights of Preference Shareholders may be as follows or as set out in the Company’s
constitution:
 Preference shareholders have a priority right over ordinary shareholders to a return of their
capital if the company goes into liquidation.
 Preference shares do not carry a right to vote
Classification of Preference Shares
 Redeemable Preference Shares mean that the company will redeem (repay) the nominal
value of those shares at a later date. For example, redeemable 5% $1 preference shares
20X9 means that the company will pay these shareholders$1 for every share they hold on a
certain date in 20X9. The shares will then be cancelled and no further dividends paid.
Redeemable preference shares are treated like loans and are included as non-current
liabilities in the statement of financial position. It is usually reclassified as current liabilities
if the redemption becomes due within 12 months. Dividend paid on redeemable
preference shares are treated like interest paid on loans and are included in financial costs
in the income statement.
 Irredeemable Preference Shares are treated just like other shares. They form part of equity
and their dividends are treated as appropriations of profit.
Types of Preference Shares
1. Non-cumulative Preference Shares – These can receive a dividend up to an agreed percentage
each year. If the amount paid is less than the maximum agreed amount, the shortage is lost by
the shareholders. They cannot carry forward that shortage and get it in the future year.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
2. Cumulative Preference Shares – These also have an agreed maximum percentage dividend.
However any shortage of dividend paid in a year can be carried forward. These arrears of
preference dividends will have to be paid before the ordinary shareholders receive anything.
B. Ordinary Shares – are shares which are not preferred with regard to dividend payments. Thus a
holder only receives divided after fixed dividends have been paid to preference shareholders.
There is no upper limit to the amount of dividends they can receive. Generally, however, only part
of such remaining profits is distributed, the rest being kept in reserve.
Should the company be wound up, any surplus not distributed is shared between the ordinary
shareholders. Ordinary shares normally carry voting rights.
Ordinary shareholders are thus the effective owners of a company. They own the equity of the
business, and any reserves of the business belong to them. Ordinary shareholders are sometimes
referred to as equity shareholders. (Preference shareholders are in many ways more like payables
of the company, although legally they are members, not payables.)
Different Meanings of Share Capital
The term ‘share capital’ can have any of the following meanings:

Authorized Share Capital – Sometimes known as registered capital or nominal capital. This is
the maximum of the share capital, which the company is allowed to issue to shareholders,
which can only be changed by agreement. For example The Normandy Company might be
authorized by its charter to issue a maximum 500,000 ordinary shares of $1 each.

Issued Share Capital – This is the total of the share capital actually issued to shareholders. If all
of the authorized share capital has been issued, then both authorized and issued share capital
would be the same amount. However, the amount of issued capital cannot exceed the amount
of authorized capital. For example, out of the 500,000 ordinary $1 share the Normandy
Company issued 400,000 shares. This would leave it the option to issue 100,000 more shares at
some time in the future.
When share capital is issued, shares are allotted to shareholders. The term allotted share
capital is means the same thing as issued share capital.

Called-up Capital – When shares are issued or allotted, a company does not always expect to
be paid the full amount for the shares at once. It might instead call up only a part of the issue
price, and wait until at a later time before it calls up the reminder. Where only part of the
amounts payable on each share has been asked for, the total amount asked for on all shares is
known as the called-up capital.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
For example, since Normandy Company allotted 400,000 ordinary shares $1, it might call up
only, say, 75 cents per share. The issue share capital would be $400,000, but the called-up
share capital would only be $300,000

Uncalled Capital – This is the total amount that is to be received in future, but which has not
yet been asked for. As such, from the example above the uncalled share capital will be
$100,000.

Paid up Capital – Like everyone else, investors are not always prompt or reliable payers. When
capital is called up shareholders might delay (or even default on payment). This is the total of
the amount of share capital that has been paid for by shareholders. It is the amount of calledup capital that has been paid
For example, if Normandy only received payments on the share capital called-up of $290,000,
then this is their paid up capital and there is $10,000 of calls in arrears.

Calls in arrears – The total amount for which payments has been asked for (i.e. called for), but
has not yet been paid shareholders.
The statement of financial position would appear as follows:
Assets
Calls in Arrears
10,000
Cash (called-up capital paid)
290,000
300,000
Equity
Called-up ordinary share capital
(400,000 ordinary shares of $1, with 75c per share called up)
300,000
Issuance of Shares/Stock
Stocks or shares for companies are usually issues at:



Par Value
No-Par Value
Stated Value
Illustration
Dillon Snowboards Inc. was authorized to issue 500,000, $10 Par Value ordinary shares & 100,000, Par
Value, $100 preferred shares. The Belize Family was issued 30,000 ordinary shares at par value. Mr.
Amsterdam was issued with a similar amount of shares at $12 per share. Lillian was given a special
concession to purchase 10,000 par value ordinary shares at $8 per share. Before the company was
formed James was issued with 1,000 ordinary @ $40 per share in order to raise funds for pay the
startup cost of the company. The directors had also decided just before the share prices were set to
issue James with a further 5,000 $40 stated value ordinary shares at $50 per share. Mark was issued
with 40,000 par value ordinary shares in exchange for a land valued at $200,000 and building value at
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
$250,0000. Ram’s Consultancy chose to render their services ($30,000) in exchange for 3,000 par value
ordinary shares. Dominoes Investments purchased 10,000, par value Preferred shares at $110 per
share.
Par Value Stock
Many stocks carry a value called par value that is established at the time the stock is authorized. Par
value stock is a class of stock assigned a par value per share by the company in its charter. Par Value
stock can be issued at par, at a premium, or at a discount. In each of these transactions, the stock may
be exchanged for either cash or non-cash assets.
Issuing Par Value Stock at a par –When we issue common stock at par value, we record amounts for
both the asset (s) received and the par value stock issued, Stock is most commonly issued in exchange
for cash.
Issuing Par Value stock at a Premium –A premium on stock is an amount paid in excess of par by the
purchasers of issued stock. When a company sells its stock for more than par value, the stock is said to
be issued at a premium. This premium is reported on the statement of financial position as part of
stockholders’ equity. It is not revenue and is not listed on the income statement. Accounting for stock
sold at a price greater than its par value involves recording the premium separately from par value.
This premium accounts is called Contributed Capital Excess of Par Value. This is also called Premium
or Common Stock Account.
Issuing Par Value at a Discount – A discount on stock is the difference between par value and issue
price when the issue price is below par value. If stock is issued at less than par, the discount is debited
to a Discount on Common Stock Account. This account is a contra to the common stock account, and
its balance is subtracted from the par value of the stock on the statement of financial position. A
discount is not an expense and does not appear on the income statement.
No-Par Value Stock
No-par value stock or simply no-par stock, is stock not assigned a value per share by the corporate
charter. When no-par stock is issued and is not assigned a stated value, the amount received by the
company becomes legal capital and is recorded as Common Stock. This means the entire proceeds are
credited to a no-par stock account.
Stated Value Stock
Stated value stock is no-par stock that is assigned a “stated” value per share by the directors. When
no-par stock is issued and is assigned a stated value, its stated value becomes legal capital and is
credited to a no-par stock account. Assuming stated value stock is issued at an amount in excess of the
total stated value; the excess is credited to Contributed Capital in Excess of Stated Value, No-Par
Common Stock.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Issuing Stock for non-cash Assets
A company can receive assets other than cash in exchange for its stock. The company records the
assets received at the assets’ market values as of the date of the transaction. The stock given in
exchange is recorded at its par (or stated) value with any excess recorded in the Contributed Capital in
Excess of Par Account. If reliable market values for the assets received cannot be determined, the
market value of the stock given up is used to estimate the assets’ values.
Share Issue Costs
A company sometimes gives shares of its stock to promoters in exchange for their services in
organizing the company. The company receives the intangible asset Organization Cost in exchange for
this stock.
Issuing Stock through Subscriptions
Stock is usually sold for cash and immediately issued. However, companies issue stock through stock
subscriptions. A stock Subscription involves selling stock where the investor agrees to buy a certain
number of shares at specified future dates and prices. The typical case is when a new company is
formed and the organizer recognizes both an immediate and future need for capital. The organizers
can sell stock to investors who agree to contribute some cash now and to make additional
contributions in the future.
Accounting for Common Stock
Accounting for the issuance of common stock involves (1) identifying the sources and amounts of
contributed capital and (2) keeping contributed capital separate from retained earnings. Issuance of
stock affects only contributed capital accounts; no retained earnings accounts are affected. The
company should also distinguish between stock issued at par, premium, discount, stated value, or no
par value.
Issuing Preferred Stock
Preferred stock usually has a par value. Like common stock, it can be sold at a price different from par.
Separate contributed capital accounts are used to record preferred stock. Issuing no-par preferred
stock is similar to issuing no-par common stock. In addition, the entries for issuing preferred stock for
non-cash are treated similarly to entries for common stock.
Market Value of Shares
Market value per share is the price at which a stock is bought or sold outside of the companies
issuance or purchases. Market value is influenced by a variety of factors such as expected future
earnings, dividends, growth, and other company and economic events. Nearly all these techniques use
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
accounting information as an important input for the valuation process. However, today’s market value
of previously issued shares does not affect that organization’s shareholders’ equity accounts.
The par value of shares will be different from their market value, which is the price at which someone
is prepared to purchase shares in a company from an existing shareholder. If Mr. A Owns 1,000 $1
shares in Z Co. he may sell them to B for $1.60 each.
This transfer of existing shares does not affect Z Co’s own financial position in any way whatsoever,
and apart from changing the register of members. Z Co. does not have to bother with the sale by Mr. A
to Mr. B at all. There are certainly no accounting entries to be made for the share sale.
Shares in private companies do not change hands very often, hence their market value is often hard to
estimate. Companies listed on a stock exchange are quoted, i.e. it is the market value of the shares
which is quoted.
Reserves
Even though the shareholders receive a share of the profit, not all the profits will be paid out as
dividends. The directors calculate the net profit and decide how much to hold back as Reserves.
Reserves accounts are accounts that hold appropriated profits to be used in the future. Reserves
consists of those unused profits either remaining in the appropriation account, or transferred to a
reserve account appropriately titled, e.g. general reserve, fixed assets replacement reserves, etc.
All reserves, however, are owned by the ordinary shareholders, who own the ‘equity’ in the company.
In most countries, a distinction must be made between the following:
(a) Statutory Reserves, which are reserves a company is required to be set up by law, and which
are not available for distribution of dividends.
(b) Non-Statutory Reserves, which are reserves consisting of profits which are distributable as
dividends, if the company so wishes.
Statutory reserves are capital reserves (share premium, revaluation) and non-statutory reserves are
revenue reserves.
Loan Stock or Bonds (Debentures)
Limited liability companies may issue loan stock or bonds. These are long-term liabilities and in some
countries they are described as loan capital because they are means of raising finance, in the same way
as issuing share capital raises finance. They are different from share capital in the following ways:
1. Shareholders are members of a company, while providers of loan capital are creditors.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
2. Shareholders receive dividends (appropriations of profit) whereas the holders of loan capital
are entitled to a fixed rate of interest (an expense charged against revenue).
3. Loan Capital holders can take legal action against a company if their interest is not paid when
due, whereas shareholders cannot enforce the payment of dividends.
4. Loan stock is often secured on company assets, whereas shares are not.
The holder of loan capital is generally in a less risky position than the shareholder. He has greater
security, although his income is fixed and cannot grow, unlike ordinary dividends.
Interest is calculated on the par or legal value of loan capital, regardless of its market value. If a
company has $700,000 (par value) 12% loan stock in issue, interest of $84,000 will be charged to the
income statement per year.
Accounting for an Issue of Debentures
Another way of raising the necessary finance for a firm is to issue debentures. By this method people
lend money to a company, and are given a debenture deed, which show the rate of interest that is to
be paid on the debenture each year.
The accounting for a debenture issue follows a similar pattern to that of shares. Thus if we had 10
debentures of $1,000 each to issue and exactly this amount was applied for, then the accounts would
appear as follows: Illustration
Debentures are also called Unsecured Bonds and are backed by the issuer’s general credit standing.
Unsecured Bonds are almost always more risky that secured bonds. Because of this added risk, a
company generally must be financially strong, to successfully issue debentures at a favorable rate of
interest.
Companies also can issue debentures whose claims on company’s assets are second to those of other
unsecured liabilities. These debentures are called subordinated debentures, meaning these creditors’
claims are subordinated to the claims of some others.
Shareholders’ Equity
Shareholders’ equity consists of the following:
(a) The par value of issued capital (minus any amounts not yet called up on issued shares)
(b) Other Equity – consists of four elements:(i) Capital paid in excess of par value (Share premium)
(ii) Revaluation Surplus
(iii) Reserves
(iv) Retained Earnings
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Share Premium – is the difference between the issue price of the share and its par value. If a company
does well, the market value of its shares will increase, but not the par value. The difference between
cash received by the company and the par value of the new shares issued is transferred to a Share
Premium Account. The share premium account cannot be distributed as dividend under any
circumstances so as to maintain the capital base of the company and provide some security to
creditors.
Revaluation Surplus – is the result of an upward revaluation of non-current assets. This is nondistributable as it represents unrealized profits on the revalued assets. It is another capital reserve.
The relevant part of a revaluation surplus can only become realized if the asset in question is sold, thus
realizing the gain. The revaluation surplus may fall, however, if an asset which had previously been
revalued upwards suffered a fall in value in the next revaluation.
Retained Earnings – are profits earned by the company and not appropriated by dividends, taxation or
transfer to another reserve account. This is the most significant reserve and is variously described as:
a)
b)
c)
d)
e)
Revenue Reserve
Retained Profits
Accumulated Profits
Undistributed Profits
Unappropriated Profits
Accumulated Retained Earnings over the years can be used to pay dividends even if a loss has been
made or profit is low in one particular year. A debit balance on the retained earnings account indicates
that the company has accumulated losses.
For example, if a company makes a loss of $100,000 in one year, yet has unappropriated profits from
previous years totalling $250,000, it can pay a dividend not exceeding $150,000.
Financial Statements of Limited Liability Companies
The accounting rules and conventions are much the same as for sole traders. Companies will have a
cash book, sales day book, purchase day book, journal, sales ledger, purchases ledger and nominal
ledger. They will prepare an Income Statement annually and a statement of financial position at the
end of the accounting year.
The financial statements of limited liability companies are usually governed by national legislation and
accounting standards. From an international standpoint, however, the general content of financial
statements is governed by IAS 1 Presentation of Financial Statements. This standard is concerned
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
with financial statements produced for external reporting purposes, that is, external users. The
standard looks at the statement of financial position and income statement.
Income Statement
The Income Statement is the most significant indicator of a company’s financial performance. IAS 1
stipulates that all items of income and expense recognized in a period shall be included in profit and
loss unless a standard or an interpretation requires otherwise.
The Accounting Concepts used for a Company’s Income Statement are similar to those of a Sole
Trader, that is The Matching Concept, that applies to revenue and expenses so that there would be
need to adjust for accruals and prepayment.
There are two main expenses that are found in a Limited Company’s Income Statements that is
different from that of a Sole Trader’s Income Statement:
1. Directors’ Remuneration – Directors are legally employees of the company, appointed by the
shareholders. Their remuneration is charged to the main profit and loss account, even when
the director is also a shareholder.
2. Loan Stock/Debenture Interest – The term debenture/loan stock refers to monies received by
the company as a loan from someone. A special written agreement shows all the agreed terms
for the debenture. For this loan, the lender is paid interest at an agreed percentage. This is
known as debenture interest. It must be paid even if the company is making a loss. In contrast,
dividends are payable only if profits have been made. Debenture interest is an expense to be
charged in the main profit and loss account.
The Appropriation Account
The Appropriation account shows how the profits are to be appropriated or used.




Net Profit for the year – This is the net profit brought down from the main profit and loss
account.
Balance brought forward from the last year – Not all profit may be appropriated during a
period. This then will be the balance on the appropriation account, as brought forward from
the previous year.
Transfers to reserves – The directors may decide that some of the profits should not be
included in the calculation of how much should be paid out as dividends. These profits are
transferred to reserve accounts. There may be a specific reason for the transfer, such as a
need to replace fixed assets; in this case an amount would be transferred to a fixed assets
replacement reserve. Or the reason may not be specific; in this case an amount would be
transferred to a general reserve account.
Amounts written off as goodwill – Goodwill in a company may have amounts written off it
from time to time. When this is done the amount written off should be shown in the
appropriation account and not in the main profit and loss account.
LECTURE NOTES
UNIVERSITY OF GUYANA
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ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Amounts written off as preliminary expenses – When a company is formed, there are many
kinds of expenses concerned with its formation, e.g. legal expenses and various government
taxes. The amount of the preliminary expenses can be written off and charged in the
appropriation account.
Taxation payable on profits – Taxation is an appropriation of profits and would be shown as a
debit in the appropriation account. It affects both the statement of financial position and the
income statement; where the charge for the year is shown as a deduction from net profit and
as a tax payable (current liability) to the government in the statement of financial position. All
companies pay some kind of corporate taxation on the profits they earn, since the company has
a separate legal personality. This tax is included in their accounts.
Dividends – are appropriations of profit after tax. Out of the remainder of the profits, the
directors propose the amount of dividends to be paid.
Balance carried forward to next year – After the dividends have been proposed, there will
probably be some profits that have not been appropriated. These profits will be carried
forward to the following year. These are usually known as retained profits.
Interrelationship of Income Statement and Statement of Financial Position
When we were with dealing financial statements of sole traders, we transferred the net profit to
capital account. In the case of limited liability companies, the net profit is transferred to retained
earnings in the statement of changes in equity (SOCIE). The closing balance of the accounts in the
SOCIE is then transferred to the statement of financial position.
The Statement of Financial Position
The statement of financial position must conform to the regulations specified in the Companies Act.




Non-current assets – include tangible and intangible operating and financial assets of a longterm nature. They should normally be shown at cost or at some other valuation. In either case
the method chosen should be clearly stated. However, only the totals are shown on the face of
the statement of financial position; the details are given in the notes.
The total depreciation - from the date of purchase to the date of the statement of financial
position should be shown clearly in the notes.
Current Assets – should be classified as such when it:
o is expected to be realized, or is held for sale or consumption in, the entity’s normal
operating cycle; or
o is held primarily for the purpose of being traded
o is expected to be realized within 12 months after the reporting date
o is cash or cash equivalent which is not restricted in its use.
Equity – Movements in share capital and reserves must be reported in the statement of
changes in equity (SOCIE).
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Capital reserves usually have to be set up by law, whereas revenue reserves are appropriations
of profit. With a sole trader, profit was added to capital. However, in a limited liability
company, share capital and profit have to be disclosed separately, because profit distributable
but share capital cannot be distributed. Therefore retained profits are kept in the retained
earnings reserve.
In addition, the authorized share capital when it is different from the issued share capital is
shown as a note. It is not added into the statement of financial position totals.
When shares are only partly called up, it is the amount actually called up that appears in the
statement of financial position and not the full amount.
A total for share capital plus reserves should be shown.
 Stockholders’ Equity - The equity of a company is known as stockholders’ equity, also called
shareholders’ equity or corporate capital. Stockholders’ equity consists of (1) contributed (or
paid-up) capital (2) retained earnings. Contributed Capital is the total amount of cash and other
assets received by the corporation from its stockholders in exchange from common stock.
Retained Earnings is the cumulative net income retained in a company.
 Concepts – The statement of financial position makes use of the accounting concepts that:
Assets = Capital + Liabilities
The statement of financial position is also prepared according to the Business Entity
Convention (that a business is separate from its owners).
 Liabilities – are split between current and non-current or as a consequence decision whether or
not to classify such. When an entity chooses not to classify it liabilities into current and noncurrent, it should present them broadly in order of their liquidity.
 Current Liabilities – A liability should be classified as a current liability when it:
o is expected to be settled in the entity’s normal operating cycle; or
o is due to be settled within 12 months of the reporting date
o is held primarily for the purpose of being traded.
There are also current liabilities which are not settled as part of the normal operating cycle, but
which are due to be settled within 12 months of the reporting date. These include bank
overdrafts, income taxes, other non-trade payables and the current portion of interest-bearing
liabilities. Any interest-bearing liabilities that are used to finance working capital on a longterm basis, and that are not due to for settlement within 12 months, should be classed as noncurrent liabilities.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Accounting for Limited Liability Companies
WORKSHEET
Question 1
Draw up a statement of financial position for a limited liability company R.O. Ltd from the following at
December 31, 2004
$
Premises at cost
45,000
Machinery at cost
24,000
Fixtures at cost
12,000
Inventory
18,000
Bank
6,000
Trade Receivables
9,000
Depreciation to date:
Premises
18,000
Machinery
7,200
Fixtures
4,800
Authorized Share Capital: Ordinary share $1
60,000
Issued Share Capital: fully paid
36,000
Debentures: 10%
18,000
Proposed dividend owing
3,000
Trade Payables
9,000
General Reserve
15,000
Income Statement Profit
?
Question 2
C.A. Company Ltd. Manufacturing agricultural implement, made a net profit after taxation of $210,000
for the year to December 31, 2002. Retained profits at December 31, 2001 amounted to $17,000. At
the directors’ meeting, the following were agreed.
To be transferred to general reserve
To be transferred to foreign exchange reserve
Goodwill to be written off
$
30,000
5,000
11,000
It has also been agreed that a dividend of 10% be proposed on the ordinary share capital. This
amounted to 500,000 shares of $2 each.
Preference share dividends of 10% had been paid during the year on 250,000 preference shares of $1
each. You are required to draw up the company’s profit and loss appropriation account for the year
ended December 31, 2002.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Question 3
Barton Corporation began operations on January 1, 1999. The following transactions relating to
stockholders’ equity occurred in the first two years of the company’s’ operations.
1999
Jan 1 Authorized the issuance of 2 million shares of $5 par value common stock and 100,000 shares
of $100 par value, 10 % cumulative, preferred stock.
Jan 2 Issued 200,000 shares of common stock for cash at $12 per share.
Jan 3 Issued 100,000 shares of common stock in exchange for a building valued at $820,000 and
merchandise inventory valued at $380,000.
Jan 4 Paid cash to company’s founders for $100,000 of organizations costs; these costs are to be
amortized over 10 years.
Jan 5 Issued 12,000 shares of preferred stock at $110 per share.
2000
June 4 Issued 100,000 shares of common stock for cash at $15 per share.
Required
1. Prepare journal entries to record these transactions.
2. Prepare the stockholders’ equity section of the statement of financial position as at December
31, 1999 and December 31, 2000, based on these transactions.
3. Prepare a schedule showing dividend allocations and dividends per share for 1999 and 2000
given Barton declares the following cash dividend
1999 …. $50,000
2000 …. $300,000
4. Prepare the journal entry for Barton’s issuance of $200,000 shares of common stock for cash
at $12 per share assuming:
a)
Common Stock in no-par stock without a stated value
b)
Common Stock is no-par stock with a stated value of $10 per share.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Question 4
USB, a limited liability company, has the following trial balance at 31 December 20X9.
Debit
$’000
100
2,400
2,206
650
Cash at bank
Inventory at 1 January 20X9
Administrative expenses
Distribution costs
Non-current assets at cost:
Buildings
Plant and equipment
Motor vehicles
Suspense
Accumulated depreciation
Buildings
Plant and equipment
Motor vehicles
Retained earnings
Trade receivables
Purchases
Dividend paid
Sales revenue
Sales tax payable
Trade payables
Share premium
$1 ordinary shares
Credit
$’000
10,000
1,400
320
1,500
4,000
480
120
560
876
4,200
200
22,352
11,752
1,390
1,050
500
1,000
22,352
The following additional information is relevant.
(a) Inventory at 31 December 20X9 was valued at $1,600,000. While doing the inventory count,
errors in the previous year’s inventory count were discovered. The inventory brought forward
at the beginning of the year should have been $2.2m, not $2.4m as above.
(b) Depreciation is to be provided as follows:
(i)
Buildings at 5% straight line, charged to administrative expenses.
(ii)
Plant and equipment at 20% on the reducing balance basis, charged to cost of sales.
(iii)
Motor vehicles at 25% on the reducing balance basis, charged to distribution costs.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
(c) No final dividend is being proposed.
(d) A customer has gone bankrupt owing $76,000. This debt is not expected to be recovered and
an adjustment should be made. An allowance for receivables of 5% is to be set up.
(e) 1 million new ordinary shares were issued at $1.50 on 1 December 20X9. The proceeds have
been left in a suspense account.
Required
Prepare the income statement for the year to 31 December 20X9, a statement of changes in equity
and a statement of financial position at that date in accordance with the requirements of
International Financial reporting Standards. Ignore taxation.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Reporting & Analyzing Cash Flows
Lecture Notes
Profitability is a primary goal of most managers. But it is not the only goal. A company cannot achieve
or maintain profits without careful management of cash.
Manager (internal users) and other users (external users) of information pay close attention to a
company’s cash position and the events and transactions affecting cash. Internal users rely on the
statement of cash flows to make investing and financing decisions. External users rely on this
statement to assess the amount and timing of a company’s cash flows. Information about these events
and transactions are reported in the statement of cash flows.
International Accounting Standards define cash flows as the Net Monetary Assets – meaning cash
demand deposits, and highly liquid investments minus short-term loans. An income statement reports
revenues, gains, expenses, and losses on an accrual basis (earned or incurred). The statement of cash
flows reports cash received and cash paid for operating, financing, and investing activities.
Purpose of the Statement of Cash Flows
The purpose of the statement of cash flows is to report all major cash receipts (inflows) and cash
payments (outflows) during a period. This includes separately indentifying the cash flows related to
operating, investing, and financing activities.
The statement of cash flows does more than simply report changes in cash. It is the detailed disclosure
of individual cash flows that makes this statement useful to users. Information in this statement helps
users answer questions such as:
 How does a company obtain its cash?
 Where does a company spend its cash?
 What explains the change in the cash balance?
The statement of cash flows addresses these important questions by summarizing, classifying, and
reporting a company’s cash inflows and outflows for each period.
Importance of Cash Flows
Cash Flows are important because:
 We look more favourably at a company that is financing its expenditures with cash from
operations than one that does it by selling its assets.
 Information about cash flows also helps users decide whether a company has enough cash to
pay its existing debts as they mature.
LECTURE NOTES
UNIVERSITY OF GUYANA
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ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
It is also relied upon, especially by external users, to evaluate a company’s ability to meet
unexpected obligations and pursue unexpected opportunities.
Internal users such as managers use cash flow information to plan day-to-day operating
activities and make long-term investment decisions.
Measuring Cash Flows
The Statement of Cash Flows measures the difference between the beginning and ending balances of
cash and cash equivalents.
Classifying Cash Flows
All cash and cash equivalent receipts (except for cash received from selling cash equivalents) and
payments are classified and reported on the statement as Operating, Investing, or Financing activities.
Individual cash receipts for each of these categories are labeled to identify their source transactions or
events. Cash receipts and payments are then summarized for each category by netting them against
each other. A net cash inflow (source) occurs when the receipts in a category exceed the payments. A
net cash outflow (use) occurs when the payments in a category exceed the receipts.
Operating Activities
Operating activities include the cash effects of transactions and events that determine net income.
Some examples include the production and purchase of merchandise, the sale of goods and services to
customers, and expenditures toward administering the business. But not all items in income, such as
unusual gains and losses, are operating activities.
Cash Inflows: Cash is received from sales to customers, collection on credit sales, lawsuit settlements,
interest from borrowers, cash dividends received and selling of trading securities
Cash Outflows: Cash is paid for salaries and wages, to lenders for interest, to charities, to purchase
trading securities, to suppliers for goods and services, and to government taxes and fines.
Investing Activities
Investing activities include the (a) purchase and sale of long term assets, (b) the purchase and sale of
short term investments other than cash equivalents, and (c) lending and collecting money the company
loan to others. However, the interest collected on those loans should be reported as an operating
activity.
Cash Inflows: Cash is received from selling equity investments, selling (discounting) of loans, collecting
principal on loans, selling long-term productive assets and selling debt investments.
Cash Outflows: Cash is paid to make loans to others, to purchase debt investments, to purchase longterm assets and to purchase equity investments.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Financing Activities
Financing activities include (a) obtaining cash from issuing debt (debentures/bonds) and repaying the
amounts borrowed, and (b) obtaining cash from or distributing cash to owners (shares and dividends).
These activities all involve transactions with a company’s owners and creditors. They also involve the
borrowing and repaying of principal amounts relating to both short and long-term debt. But payments
of interest expense are classified as operating activities.
Cash Inflows: Cash is received from contributions by owners, issuing bonds and notes, issuing its own
equity stock, issuing short-term and long-term debt
Cash Outflows: Cash is paid to repay cash loans, to pay withdrawals by owners, to pay dividends to
shareholders and to purchase treasury stock.
Noncash Investing and Financing
There are often important investing and financing activities that do not affect cash receipts or
payments. Yet because of their importance and the full disclosure principle, these important noncash
investing and financing activities are disclosed at the bottom of the statement of cash flows or in a
note to the financial statement. One example of such a transaction is the purchase of long term assets
by giving a long term note payable. This transaction involves both investing and financing activities but
it does not affect any cash inflows or outflow and is not reported in any of the three sections of the
statement of cash flows. Some other examples are:
 Retirement of debt by issuing shares
 Conversion of preferred shares to ordinary shares
 Leasing of assets in capital lease transaction
 Purchase of long-term asset by issuing a note or bond
 Exchange of noncash assets for other noncash assets
 Purchase of noncash assets by issuing equity or debt.
Format of the Statement of Cash Flows
Accounting standards require companies to include a statement of cash flows in a complete set of
financial statements. This statement must report information about a company’s cash receipts and
cash payments during the period.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
COMPANY NAME
Statement of Cash Flows
For the period Ended (Date)
$
Cash Flows from operating activities
[List of individual inflows and outflows]
Net cash provided (used) by operating activities ………..………
Cash Flows from investing activities
[List of individual inflows and outflows]
Net cash provided (used) by investing activities …………..……
Cash Flows from financing activities
[List of individual inflows and outflows]
Net cash provided (used) by financing activities ……………….
Net increase (decrease) in cash ……………………………….…
Cash (and equivalents) balance at the beginning of period
Cash (and equivalents) balance at the end of period
####
####
####
####
####
####
Preparing the Statement of Cash Flows
Preparation of a statement of cash flows involves five (5) steps:
1. Compute the net increase or decrease in cash. It equals the current period cash balance minus
the prior period’s cash balance.
2. Compute and report net cash provided (used) by operating activities (using either the direct or
indirect method);
3. Compute and report net cash provided (used) by investing activities;
4. Compute and report net cash provided (used) by financing activities ;
5. Compute net cash flows by combining net cash provided (used) by operating, investing and
financing activities and prove it by adding it to the beginning cash balance to show it equals the
ending balance.
Information to Prepare the Statement
Information to prepare the statement of cash flows usually comes from three sources:
1. Comparative Statements of Financial Position at the beginning and end of the period.
2. Current Income Statement
3. Additional Information
Comparative statements of financial position give us changes in non-cash accounts from the beginning
to the end of the period. The current income statement gives us details to help compute cash flows
from operating activities. Additional information often includes details on transactions and events
helping us explain both the cash flows and noncash investing and financing activities.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Reporting Operating Cash Flows
The net cash flows provided (used) by operating activities can be reported in one of two ways: the
Direct Method or the Indirect Method. The Direct Method separately lists each major item of
operating cash receipts (such as cash received from customers) and each major item of operating cash
payments (such as cash paid for merchandise). The cash payments are subtracted from cash receipts
to determine the net cash provided (used) by operating activities. The Indirect Method reports net
income and then adjusts it for items necessary to give us net cash provided (used) by operating
activities. It does not report individual items of cash inflows and cash outflows from operating
activities. Instead, the indirect method reports the necessary adjustments to reconcile net income to
net cash provided (used) by operating activities. A common adjustment is a subtraction for
depreciation. Since depreciation expense is not a current cash payment, we add depreciation expense
back to net income in our process of adjusting net income to get net cash provided (used) by operating
activities.
The indirect method of reporting cash flows does not provide as much detail about the sources and
uses of cash as does the direct method. The direct method also is recommended by the FASB. But
since the direct method is not required and the indirect method is arguably easier to compute, most
companies report operating cash flows using the indirect method.
Direct Method of Reporting
We compute cash flows from operating activities under the direct method by adjusting accrual based
income statement items to a cash basis. The usual approach is to adjust income statement accounts
as follows:
Revenue
Or
Expense
Adjustments for
Changes in Related
SOFP Accounts
Some of the major classes of operating cash flows are:
 Operating Cash Receipts
o Customers
o Renters
o Interest
o Dividends
 Operating Cash Payments
o Suppliers
o Employees
o Operations
o Interest
o Taxes
LECTURE NOTES
Cash Receipts
Or
Cash Payments
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Illustration Financial Statements
GENESIS
Statement of Financial Position
As at December 31, 2000 and 1999
2000
1999
Assets
$
$
Non Current Assets
Plant Assets
250,000
210,000
Accum. Depreciation
60,000
48,000
Total Non-Current Assets
190,000
162,000
GENESIS
Income Statement
For Year Ended December 31, 2000
$
$
Sales
590,000
Cost of Goods Sold
300,000
Wages & Op Exp
216,000
Interest Expense
7,000
Depreciation
24,000 (547,000)
Current Assets
Inventory
Trade Receivables
Cash
Prepaid Expenses
Total Current Assets
Total Assets
Other gains (losses):
Loss on sale plant assets
Income before taxes
Income taxes expense
Equity & Liabilities
Shareholders’ Equity
Ordinary Share, $5 par
Retained Earnings
Total Shareholders’ Equity
Non Current Liabilities
Bonds payables
Current Liabilities
Trade Payables
Interest Payables
Income Tax Payable
Total Current Liabilities
Total Liabilities
Total Equity and Liabilities
84,000
60,000
17,000
6,000
167,000
357,000
70,000
40,000
12,000
4,000
126,000
288,000
Income from continuing op.
(6,000)
37,000
(15,000)
22,000
Extraordinary item:
Gain on retirement of debt
95,000
112,000
207,000
80,000
88,000
168,000
90,000
64,000
35,000
3,000
22,000
60,000
150,000
357,000
40,000
4,000
12,000
56,000
120,000
288,000
NET INCOME
16,000
38,000
Genesis discloses additional information about year 2000 transactions as follows:
(a) Trade Payables balance result from merchandise purchases
(b) Plant assets costing $70,000 are purchased by paying $10,000 cash and issuing $60,000 of bonds payable.
(c) Plants assets with an original cost of $30,000 and accumulated depreciation of $12,000 are sold for
$12,000 cash. This yields a $6,000 loss.
(d) Cash received from issuing 3,000 shares of common stock is $15,000.
(e) Paid $18,000 to retire bonds with a book value of $34,000. This yields a $16,000 gain.
(f) Cash dividends of $14,000 are declared and paid.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Operating Cash Receipts
Genesis suggests only one potential cash receipt- sales to customers.
Cash Received from Customers – If all the sales are for cash, the amount of cash received from
customers is equal to sales reported on the income statement. But when some are on account,
we must adjust the amount of sales revenue for the changes in Trade Receivable. This is done by
using a T account analysis as shown below
Balance 12/31/1999
Sales
Trade Receivable
$
40,000 Cash Collection
590,000 Balance 12/31/2000
630,000
$
570,000
60,000
630,000
A trade receivable increase implies cash is less than sales and the converse is also true. As such, cash
received from customers can also be derived from deducting an increase or adding a decrease in trade
receivable to sales.
Other cash receipts follow the same logic as above in computing their cash receipts. Therefore we
compute cash received from these items by subtracting an increase in their respective receivable or
adding a decrease.
Operating Cash Payments
Genesis shows four (4) operating expenses - cost of goods, wages and other expenses, interest, and
taxes – all of which should be analyzed to compute their cash payments for the cash flow statement.
Cash Paid for Inventory – Cash paid for inventory is computed by analyzing both the cost of goods sold
and the inventory. If all inventories purchased are for cash and the ending balance of inventory is
unchanged from the beginning balance, then the amount of cash paid for Inventory equals cost of
goods sold. This is usually an uncommon occurrence and as such when the balances in Inventory and
Trade Payables change, we must adjust cost of goods sold for changes in both of these accounts to
compute cash paid for merchandise. This is a two (2) step adjustment. First, we use the change in the
account balance of Inventory along with cost of goods sold amount to compute cost of purchases for
the period. If Inventory increases, it implies we bought more than was sold and we add this inventory
to cost of goods sold to compute cost of purchases. If Inventory decreases, it implies we bought less
than was sold and we subtract the inventory decrease from cost of goods to compute purchases.
The second step uses the change in the balance of trade payables along with the amount of cost of
purchases to compute cash paid for merchandise. If trade payables decrease, it implies we paid for
more goods than we acquired this period, and we then add the trade payables decrease to cost of
purchases to compute cash paid for inventory. If trade payables increases, it implies we paid for less
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
than the amount of goods acquired, and we subtract the trade payables increase from the purchases
to compute cash paid for merchandise. This is done by using a T account analysis as shown below:
Balance 12/31/1999
Cost of Purchases
Cash Payments
Balance 12/31/2000
Inventory
$
70,000 Cost of goods sold
314,000 Balance 12/31/2000
384,000
$
300,000
84,000
384,000
Trade Payables
$
319,000 Balance 12/31/1999
35,000 Purchases
354,000
$
40,000
314,000
354,000
Cash Paid for Wages and Operating Expenses (Excluding Depreciation) – To compute cash paid for
wages and other operating expenses, we adjust this amount for any changes in their related statement
of financial position accounts. We begin by looking for any prepaid expenses and accrued liabilities
related to wages and other operating expenses in the statement of financial position. Genesis has
prepaid expenses but no accrued liabilities. This means its adjustment is limited to the change in
prepaid expenses. The T account analysis is shown below:
Balance 12/31/1999
Cash Payments
Prepaid Expenses
$
4,000 Wages & Other Operating Exp.
218,000 Balance 12/31/2000
222,000
$
216,000
6,000
222,000
If accrued liabilities decrease, it implies we paid cash for more goods or services than received this
period, and we must add the decrease in accrued liabilities to the expense amount to get cash paid for
these goods or services. If accrued liabilities increase, it implies we paid cash for less than what was
acquired and we must subtract this increase in accrued liabilities from the expense amount to get cash
paid.
Cash Paid for Interest and Income Taxes – The analysis for computing operating cash flows for interest
and taxes is similar to that for operating expenses. Both require adjustments to their amounts
reported on the income statement for changes in their related statement of financial position
accounts.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Interest Payable
$
8,000 Balance 12/31/1999
3,000 Interest Expense
Interest Paid
Balance 12/31/2000
11,000
Income Taxes Payable
$
5,000 Balance 12/31/1999
22,000 Income taxes Expense
27,000
Interest Paid
Balance 12/31/2000
$
4,000
7,000
11,000
$
12,000
15,000
27,000
Analysis of Additional Expenses, Gains, or Losses – Genesis has three (3) additional items reported on
its income statement: depreciation, loss on sale of assets, and gain on retirement of debt.
Depreciation is the allocation of the depreciable cost of a purchased asset and as such it is a noncash
expense which results in no cash flows. Sales of assets frequently result in Gains or Losses which is
reported as part of net income. However, the gain or loss is not cash flow but the recognition of the
difference between the net book value of the asset the cash inflow received. The retirement of a debt
usually yields a loss or gain, but the amount recorded does not reflect cash flows.
All of the above mentioned noncash items are not reported on the statement of cash flows using the
direct method. Depletion and amortization expenses are treated similarly.
Summary of Selected Adjustments for Direct Method
ITEM
From Income
Statement
Adjustments to get Cash Flow Numbers
Receipts:
From Sales
Sales Revenue
From Rent
Rent Revenue
From Interest
Interest Revenue
From
Dividends
Payments:
Dividends
Revenue
To Suppliers
For Operations
To Employees
Cost of Goods
Sold
Operating
Expense
Wages (Salaries)
Exp.
For Interest
Interest Expense
For Taxes
Income Tax
Expense
Add
Less
Add
Less
Add
Less
Add
Less
Decrease in Trade Receivable
Increase in Trade Receivable
Decrease in Rent Receivable
Increase in Rent Receivable
Decrease in Interest Receivable
Increase in Interest Receivable
Decrease in Dividends Receivable
Increase in Dividends Receivable
Add
Less
Add
Less
Add
Less
Add
Less
Add
Less
Increase in Inventory
Decrease in Inventory
Increase in Prepayments
Decrease in Prepayments
Decrease in Wages (Salaries) Payable
Increase in Wages (Salaries) Payable
Decrease in Interest Payable
Increase in Interest Payable
Decrease in Income Tax Payable
Increase in Income Tax Payable
LECTURE NOTES
Add
Less
Add
Less
Decrease in Trade Payable
Increase in Trade Payable
Decrease in Accrued Liabilities
Increase in Accrued Liabilities
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
Direct Method of Reporting Operating Cash Flows (GENESIS)
Cash flows from Operating activities:
$
Cash received from Customers
570,000
Cash paid for Inventory
(319,000)
Cash paid for Wage and Other Operating Expenses
(218,000)
Cash paid for Interest
(8,000)
Cash paid for Taxes
(5,000)
Net Cash provided by Operating Activities
TROY J. WISHART
$
20,000
Indirect Method of Reporting
Net Income is computed using accrual accounting. Accrual accounting recognizes revenues when
earned and expenses when incurred. But revenues and expenses do not necessarily reflect the receipt
and payment of cash. The indirect method of computing and reporting net cash flows from operating
activities involves adjusting the net income figure to get the cash provided (used) by operating
activities. This includes subtracting noncash credits from net income and adding noncash charges
(debits) back to net income. However, both the direct and indirect method of reporting net cash flow
provided (used) by operating activities. Only the computations and presentation are different.
The indirect method does not report individual operating cash inflows or cash outflows. Instead, the
indirect method adjusts net income for three types of adjustments. First, there are adjustments for
changes in noncash current assets and current liabilities relating to operating activities. Second, there
are adjustments to net income statements items involving operating activities that do not affect cash
inflows or outflows in the period. Third, there are adjustments to eliminate gains and losses resulting
from investments and financing activities (those not part of operating activities).
Adjustments for Changes in Noncash Current Assets – Changes in noncash current assets are normally
the result of operating activities. Some examples are sales affecting trade receivables and expenses
affecting prepayments. Noncash current assets will either decrease or increase depending on whether
or not cash is received or paid for their corresponding operating activities. Net Income if adjusted by
the cash flows, that results from increases and decreases in noncurrent assets, will adjust the net
income figure to get the net cash provided (used) by operating activities. To accomplish this:


Increases in noncash current assets are subtracted from net income
Decreases in noncash current assets are added to net income
In the example of Genesis, the noncash current assets are trade receivables, inventory and
prepayments, which corresponds with sales, cost of goods, sold and the expenses on the income
statement respectively. Trade Receivables increased by $20,000 in the period from a beginning
balance of $40,000 to and ending balance of $60,000. This implies Genesis collected less cash than
reported as sales, since some of the sales are in the form of accounts receivable at the end of the
period. Inventory also increased by $14,000 in the period from a beginning balance of $70,000 to an
ending balance of $84,000. This suggests that Genesis had a greater amount of cash purchases than
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
goods sold this period, the balance of which ends up in the form of inventory. Prepaid Expenses
increased by $2,000 in the period from a beginning balance of $4,000 to an ending balance of $6,000.
This suggests that the cash payment for expenses was greater than that which was reported. All of
these increases in noncash current assets will be added back to Genesis’s Net Income.
Adjustments for Changes in Current Liabilities – Similar to current assets changes in noncash current
liabilities are normally the result of operating activities. Some examples are purchases affecting trade
payables and expenses affecting accruals. The decrease in current liabilities implies that its related
Income Statement item was less than the cash actually paid. On other hand, an increase suggests that
the related income statement item was greater than the cash actually paid. As such the indirect
reporting method for reporting cash flows use the following adjustments:


Decreases in current liabilities are subtracted from net income
Increases in current liabilities are added to net income
The trade payables of Genesis decreased by $5,000 in the period, from the beginning balance of
$40,000 to an ending balance of $35,000. This decrease suggests that more money was spent for
purchases than was reported and should therefore be subtracted from Net Income. The decrease of
$1,000 in interest payable should be treated the same manner as trade payables, since it suggests that
more cash was paid for interest than was reported. However, the increase of $10,000 in income taxes
payable should be added back to net income, because not all the income taxes deducted was paid.
Adjustments for Operating Items not Providing or Using Cash
The income statement usually includes certain expenses that do not reflect cash outflows in the
period. Examples are depreciation, amortization of intangibles, depletion of natural resources, and
bad debt expense. The indirect method for reporting operating cash flows requires that Expenses with
no cash outflows are added back to net income.
Similarly, when net income includes revenues that do not reflect cash inflows in the period, the
indirect method requires that Revenues with no cash inflows are subtracted from net income.
The depreciation expense of $24,000 for Genesis should be added back to its net income since there is
no cash outflow.
Adjustments for Non-operating Items
Net income sometimes includes gains or losses that are not part of operating activities but, instead, are
classified as either investing or financing activities. Examples are gain or loss from the sale of a non
current asset or the retirement of a bond payable. The cash received or paid for the sale or retirement
of these items are recorded either under investing or financing activities. Under the indirect method
reporting operating cash flows:


Non-operating gains are subtracted from net income
Non-operating losses are added back to net income
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Hence the loss of $6,000 incurred on the sale of Genesis plant assets should be added back to net
income. On the other hand the $16,000 gain on retirement of debt should be subtracted from net
income.
Summary of Adjustments for Indirect Method
Cash flows from Operating activities:
Net Income:
Add Depreciation
Add Depletion
Add Amortization
Add Loss on Disposal of Non-current Assets
Add Loss on Retirement of Debt
Less Gain on Disposal of Non-current Assets
Less Gain on Retirement of Debt
Add Decrease in Noncash Current Asset
Less Increase in Noncash Current Asset
Add Increase in Current Liability*
Less Decrease in Current Liability*
Net Cash provided by Operating Activities
*Excludes current portion of non-current liabilities and any short-term note payables if unrelated to
sales – both are considered financing activities.
Indirect Method of Reporting Operating Cash Flows (GENESIS)
Cash flows from Operating activities:
$
Net Income
38,000
Adjustments:
Increase in Trade Receivable
(20,000)
Increase in Inventory
(14,000)
Increase in Prepaid Expenses
(2,000)
Decrease in Trade Payable
$
(5,000)
Decrease in Interest Payable
Increase in Income Taxes Payable
Depreciation Expense
Loss on Sale of Plant Assets
Gain on Retirement of Debts
Net Cash provided by Operating Activities
(1,000)
10,000
24,000
6,000
(16,000)
20,000
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Cash Flows from Investing Activities
The third major step in preparing the statement of cash flows is to compute and report net cash flows
from investing activities. This is usually done by identifying changes in all non-current asset accounts
and current accounts for notes receivable and investments in equity and debt securities (excluding
trading securities). These accounts include plant assets, intangible assets, natural resources,
investments, notes. Changes in these accounts are then analyzed using available information to
determine their effect, if any, on cash. Results of this analysis are reported in the investing activities
section of the statement of cash flows. Reporting of investing activities is identical under the direct
method and indirect method.
Investing activities include transactions such as (a) the purchase and sale of non-current assets, (b)
lending and collecting on notes receivable, and (c) the purchase and sale of short-term investments
other than cash equivalents. Information to compute cash flows from investing activities is usually
taken from beginning and ending statement of financial position and from the income statement. A
three (3) step process in determining net cash provided or used by investing activities:
(1) Identify changes in investing-related accounts;
(2) Explain these changes using reconstruction analysis;
(3) Report cash flow effects.
Analysis of Noncurrent Assets
Genesis’ financial statements reveal that it purchased and sold plant assets during the period, both of
which are investing activities.
Plant Assets – For plant assets, we need to identify the changes in both the plant asset account and its
related accumulated depreciation account. The first step reveals a $40,000 increase in plant assets
from $210,000 to $250,000, and a $12,000 increase in accumulated depreciation from $48,000 to
$60,000. What are the reasons for these changes?
The second step begins by reviewing the accounts and any additional information available. A plant
asset account is affected by both purchases and sales of plant assets. An accumulated depreciation
account normally is increased from depreciation and reduced by removing accumulated depreciation
on asset sales. Items (b) and (c) of the additional information reported for Genesis are relevant for
these accounts. To explain changes in these accounts and to help us understand the cash flows effects,
we prepare reconstructed entries. A reconstructed entry is a recreation of an entry from a
transaction, it is not the actual entry made by the preparer. Item (b) reported Genesis purchased plant
assets costing $70,000 by issuing $60,000 in bonds payable to the seller and paying $10,000 in cash.
The reconstructed entry for our analysis of item (b) is:
Plant Assets
Bonds Payable
Cash
70,000
60,000
10,000
This entry reveals a $10,000 cash outflow for assets purchased. It also reveals a noncash investing and
financing transaction involving $60,000 of bonds given up for $60,000 of plant assets.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Plant Assets Sale – Item (c) reports Genesis sells plant assets costing $30,000 (with $12,000 of
accumulated depreciation) for cash of $12,000, resulting in a loss of $6,000. The reconstructed entry
for item (c) is:
Cash
Accumulated Depreciation
Loss on Sales of Plant Assets
Plant Assets
12,000
12,000
6,000
30,000
This entry reveals a $12,000 cash inflow for assets sold. The $6,000 loss is computed by comparing the
asset book value to the cash received and does not reflect any cash inflow or outflow.
The T-account analysis to explain the change in the plant assets account and the accumulated
depreciation account are as follows:
Plant Assets
$
$
Balance 12/31/1999
210,000 Sale
30,000
Purchase
70,000 Balance 12/31/2000
250,000
280,000
280,000
Sale
Balance 12/31/2000
Accumulated Depreciation (Plant Assets)
$
12,000 Balance 12/31/1999
60,000 Depreciation Expense
72,000
$
48,000
24,000
72,000
The third step in our analysis of investing activities is to make the necessary disclosures on the
statement of cash flows. Disclosure of the two cash flow effects in the investing section statement
appears as follows:
Reporting Investing Cash Flows (GENESIS)
Cash flows from Investing activities:
Cash received from Sale of Plant Assets
Cash paid for Purchase of Plant Assets
Net Cash provided by Investing Activities
$
$
12,000
(10,000)
2,000
The $60,000 portion of the purchase described in item (b) and financed by issuance of the bonds is a
noncash investing and financing activity. This can be reported in a note or in a separate schedule
statement.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Analysis of Other Assets – Certain other assets transactions such as those involving current notes
receivable and investments in debt and equity securities are considered investing activities and can
affect a company’s cash flows. These should be analyzed using the same three-step process as
illustrated for noncurrent assets.
Cash Flows from Financing Activities
The fourth major step in preparing the statement of cash flows is to compute and report net cash flows
from financing activities. This is done by identifying changes in all non-current liability accounts
(including the current portion of any notes and bonds) and equity accounts. These accounts include
long-term debt, notes payable, bonds payable, owner’s capital, common stock, and retained earnings.
Changes in these accounts are then analyzed using available information to determine their effect, if
any, on cash. Results of this analysis are reported in the financing activities section of the statement.
Examples of financing activities are (a) receiving cash from issuing debt and repaying the amounts
borrowed and (b) receiving cash from or distributing cash to owners. A three-step process in
determining net cash provided (used) by financing activities:
(1) Identify changes in financing-related accounts;
(2) Explain these changes using reconstruction analysis;
(3) Report cash flow effects.
Analysis of Noncurrent Liabilities
Genesis had only two (2) transactions involving noncurrent liabilities, the noncash issuance of bonds
payable to purchase plant assets $60,000 and the cash retirement of bonds payable. The noncash
issuance of bonds was already disclosed as a note and as such only the retirement should be analyzed.
Bonds Payable Retirement – The comparative statement of financial position reveals an increase of
$24,000 in bonds payable from $64,000 to $90,000. Secondly a review should be done on the bonds
payable account and any additional information available. Item (e) reports that bonds with a carrying
value of $34,000 are retired for $18,000 cash, resulting in a $16,000 gain. The reconstructed entry for
the analysis is:
Bond Payable
Gain on Retirement of Debt
Cash
34,000
16,000
18,000
Reconstruction of the entry reveals a cash outflow of $18,000 and a noncash outflow of a gain on
retirement of debt. The Bonds Payable account should then be reconstructed to explain the change in
the bonds payable account.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
Retired Bonds
Balance 12/31/2000
Bonds Payable
$
34,000 Balance 12/31/1999
90,000 Issued Bonds
124,000
TROY J. WISHART
$
64,000
60,000
124,000
Analysis of Equity
Genesis reveals two transactions involving the issuance of common stock for cash, and the declaration
and payment of cash dividends.
Common Stock Issuance – The comparative statement of financial position reveals an increase of
$15,000 in common stock from $80,000 to $95,000. This change is explained to be the issuance of
3000 shares of common stock at par for $5 per share as indicated by item (d). The reconstructed entry
is as follows:
Cash
15,000
Common Stock
15,000
The common stock account will look as follows after its reconstruction:
Common Stock
$
Balance 12/31/1999
Balance 12/31/2000
95,000 Issued Stock
95,000
$
80,000
15,000
95,000
Cash Dividend Payment – There is an increase of $24,000 in Retained Earnings from $88,000 to
$112,000. Item (f) of the additional information partially explains this increase to be payment of
dividends to common stockholders of $14,000
Retained Earnings
Cash
14,000
14,000
The increase in retained earnings can also be further explained by Net Income from the Income
Statement that increases this account as follows:
Cash Dividend
Balance 12/31/2000
Retained Earnings
$
14,000 Balance 12/31/1999
112,000 Net Income
126,000
LECTURE NOTES
$
88,000
38,000
126,000
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
Reporting Financing Cash Flows (GENESIS)
Cash flows from financing activities:
Cash paid to Retire Bonds
Cash received from Issuing of Stock
Cash paid for Dividends
Net Cash provided by Financing Activities
$
TROY J. WISHART
$
(18,000)
15,000
(14,000)
(17,000)
Proving Cash Balances
The fifth and final step in preparing the statement is to report the beginning and ending cash balances
and prove that the Net Change in Cash is explained by the operating, investing and financing net cash
flows. The schedule below shows that the net increase of $5,000 in cash, from $12,000 at the
beginning of the period to $17,000 at the end, is reconciled by the net cash flows from Operating
($20,000 inflow), Investing ($2,000 inflow), and Financing ($17,000 outflow) activities. This should be
formally reported at the bottom of the statement.
Cash flows from:
$
Net Cash provided by Operating Activities
Net Cash provided by Investing Activities
Net Cash provided by Financing Activities
Net Increase in Cash
Cash Balance at Beginning of 2000
Cash Balance at End of 2000
$
20,000
2,000
(17,000)
5,000
12,000
17,000
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Complete Statement of Cash Flows (GENESIS) – Direct Method
GENESIS
Statement of Cash Flows
For the Year Ended December 31, 2000
Cash flows from Operating activities:
$
Cash received from Customers
Cash paid for Inventory
570,000
(319,000)
Cash paid for Wage and Other Operating Expenses
(218,000)
Cash paid for Interest
Cash paid for taxes
Net Cash provided by Operating Activities
$
(8,000)
(5,000)
20,000
Cash flows from Investing activities:
Cash received from Sale of Plant Assets
Cash paid for Purchase of Plant Assets
Net Cash provided by Investing Activities
12,000
(10,000)
2,000
Cash flows from financing activities:
Cash paid to Retire Bonds
Cash received from Issuing of Stock
Cash paid for Dividends
Net Cash provided by Financing Activities
(18,000)
15,000
(14,000)
(17,000)
Net Increase in Cash
Cash Balance at Beginning of 2000
Cash Balance at End of 2000
5,000
12,000
17,000
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Complete Statement of Cash Flows (GENESIS) – Indirect Method
GENESIS
Statement of Cash Flows
For the Year Ended December 31, 2000
Cash flows from Operating activities:
Net Income
Adjustments:
Increase in Trade Receivable
Increase in Inventory
Increase in Prepaid Expenses
$
38,000
$
(20,000)
(14,000)
(2,000)
Decrease in Trade Payable
(5,000)
Decrease in Interest Payable
Increase in Income Taxes Payable
Depreciation Expense
Loss on sale of Plant Assets
Gain on Retirement of Debts
Net Cash provided by Operating Activities
(1,000)
10,000
24,000
6,000
(16,000)
20,000
Cash flows from Investing activities:
Cash received from Sale of Plant Assets
Cash paid for Purchase of Plant Assets
Net Cash provided by Investing Activities
12,000
(10,000)
2,000
Cash flows from financing activities:
Cash paid to Retire Bonds
Cash received from Issuing of Stock
Cash paid for Dividends
Net Cash used by Financing Activities
(18,000)
15,000
(14,000)
(17,000)
Net Increase in Cash
Cash Balance at Beginning of 2000
Cash Balance at End of 2000
5,000
12,000
17,000
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Reporting & Analyzing Cash Flows
Worksheet
Question 1
Colby Co’s income statement for the year ended 31 December 20X2 and statements of financial
position at 31 December 20X1 and 31 December 20X2 were as follows.
COLBY CO
INCOME STAEMENT FOR THE YEAR ENDED 31 DECEMBER 20X2
$’000
Sales
Raw materials consumed
Staff costs
Depreciation
Loss on disposal of non-current asset
$’000
720
70
94
118
18
(300)
420
(28)
392
(124)
268
Profit before interest and taxes
Interest payable
Profit before tax
Taxation
Profit for the period
COLBY CO
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER
20X2
$’000
Assets
Property, plant and equipment
Cost
Depreciation
$’000
1,596
318
20X1
$’000
$’000
1,560
224
1,278
Current assets
Inventory
Trade receivables
Bank
24
76
48
1,336
20
58
56
148
1,426
Total assets
Equity and liabilities
Capital and reserves
Share capital
Share premium
Retained earnings
360
36
716
340
24
514
1,112
LECTURE NOTES
134
1,470
878
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
Non-current liabilities
Non-current loans
TROY J. WISHART
200
Current liabilities
Trade payables
Taxation
500
12
102
6
86
114
1,426
92
1,470
During the year, the company paid $90,000 for a new piece of machinery.
Dividends paid during 20X2 totalled $66,000.
Required
Prepare a statement of cash flows for Colby Co for the year ended 31 December 20X2 in
accordance with the requirements of IAS 7, using the indirect method.
Question 2
Set out below are the financial statements of Shabnum Co. You are the financial controller, faced with
the task of implementing IAS 7 Statement of cash flows.
SHABNUM CO
INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20X2
$’000
2,553
(1,814)
739
(125)
(264)
350
25
(75)
300
(140)
160
Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Interest received
Interest paid
Profit before taxation
Taxation
Profit for the period
SHABNUM CO
STATEMENTS OF FINANCIAL POSITION AS AT 31 DECEMBER
20X2
$’000
Assets
Non-current assets
Property, plant and equipment
Intangible assets
380
250
LECTURE NOTES
20X1
$’000
305
200
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Investments
Current assets
Inventories
Receivables
Short-term investments
Cash in hand
Total assets
-
25
150
390
50
2
1,222
102
315
1
948
20X2
$’000
Equity and liabilities
Equity
Share capital ($1 ordinary shares)
Share premium account
Revaluation reserve
Retained earnings
Non-current liabilities
Loan
Current liabilities
Trade payables
Bank overdraft
Taxation
Total equity and liabilities
20X1
$’000
200
160
100
260
150
150
91
180
170
50
127
85
120
1,222
119
98
110
948
The following information is available.
(a) The proceeds of the sale of non-current asset investments amounted to $30,000.
(b) Fixtures and fittings, with an original cost of $85,000 and a net book value of $45,000, were
sold for $32,000 during the year.
(c) The following information relates to property, plant and equipment
31.12.20X2
$’000
720
340
380
Cost
Accumulated depreciation
Net book value
31.12.20X1
$’000
595
290
305
(d) 50,000 %1 ordinary shares were issued during the year at a premium of 20c per share.
(e) Dividends totaling $80,000 were paid during the year.
Required
Prepare a statement of cash flows for the year to 31 December 20X2 using the format laid out
in IAS 7.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Question 3
UMLAUF COMPANY
Income Statement
For Year Ended December 31, 2000
$
Sales
Cost of Goods Sold
Other Operating expenses
Depreciation expense
Other gains (losses):
Loss on sale of equipment
Income before taxes
Income taxes expense
Income from continuing oper.
Extraordinary item:
Loss on retirement of bonds
NET INCOME
222,300
120,300
25,500
$
446,100
(368,100)
(3,300)
74,700
(13,725)
60,975
(825)
60,150
UMLAUF COMPANY
Statement of Financial Position
As at December 31, 2000 and 1999
$
Assets
2000
Cash
43,050
Trade receivable
34,125
Inventory
156,000
Prepaid expenses
3,600
Equipment
135,825
Accumulated Depreciation
(61,950)
Total Assets
310,650
$
1999
23,925
39,825
146,475
1,650
146,700
(47,550)
311,025
Equity & Liabilities
Trade payables
Income taxes payable
Dividend payable
Bonds payable
Ordinary Share, $10 par value
Retained earnings
Total Equity and Liabilities
33,750
4,425
4,500
37,500
168,750
62,100
311,025
LECTURE NOTES
28,800
5,100
0
0
168,750
108,000
310,650
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Income Taxes Expense is restated to include the tax effects from the extraordinary loss. This means
the $825 extraordinary loss is at its gross amount, and not net of tax.
Additional Information:
a) All sales are on credit.
b) All merchandise purchases are on credit.
c) Accounts Payable balances result from merchandise purchases.
d) Prepaid expenses relate to “other operating expenses.”
e) Equipment costing $21,375 with accumulated depreciation of $11,100 is sold for cash.
f) Equipment is purchases for cash.
g) Change in the balance of Accumulated Depreciation results from depreciation expense and
from the sale of equipment.
h) Change in the balance of Retained Earnings results from dividend declarations and net
income.
Required
a) Prepare a statement of cash flows using the direct method for the year 2000.
b) Prepare a statement of cash flows using the indirect method for the year 2000.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Analysis of Financial Statements
Lecture Notes
Basis of Analysis
Financial Statement Analysis is the application of analytical tools to general purpose financial
statements and related data for business decisions. It involves transforming accounting data into
useful information. It reduces uncertainty in decision making and reliance on guesses or hunches, but
does not lessen the need for expert judgement. Instead it provides an effective systematic basis for
business decisions.
Purpose of Analysis
The purpose of financial statement analysis is to help users make better decisions. These users include
decision makers both internal and external to the company.
Internal users of accounting information are those individuals involved in managing and operating the
company. They include managers, officers, internal auditors, consultants, and many other important
internal decision makers. Internal users make the strategic and operating decisions of the company.
The purpose of financial statement analysis for these users is to provide information helpful in
improving the company’s efficiency and effectiveness in providing goods and services.
External users of accounting information are not directly involved in running the company. They
include shareholders, lenders, directors, customers, suppliers, regulators lawyers, brokers and the
press. Yet these users are affected by, and sometimes affect the company’s activities. External users
rely on financial statement analysis in pursuing their own goals.
The common goal of all these users is to evaluate company performance. This includes evaluation of:
1. Past and Current Performance
2. Current Financial Position
3. Future Performance and Risk
Building Blocks of Analysis
Financial statement analysis focuses on one or more elements of a company’s financial condition or
performance. The analysis emphasizes four areas of inquiry with varying degrees of importance.
These four areas which are interrelated and are considered the building blocks of financial statement
analysis are as follows:
1. Liquidity and Efficiency – ability to meet short term obligations and to efficiently generate
revenues.
2. Solvency – ability to generate future revenues and meet long-term obligations.
3. Profitability – ability to provide financial rewards sufficient to attract and retain financing.
4. Market – ability to generate positive market expectations.
Applying the building blocks of financial statement analysis involves determining (1) the objectives of
the analysis and (2) the relative emphasis among the building blocks.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Information for Analysis
Most users rely on general-purpose financial statements that companies publish periodically. Generalpurpose financial statements include the (1) income statements, (2) statement of financial position (3)
statement of changes in equity (4) statement of cash flows and (5) notes to the statements. Generalpurpose financial statements are part of financial reporting, which refers to the communication of
relevant financial information to decision makers.
Standards for Comparisons
When computing and interpreting analysis measures as part of our financial statement analysis, we
need to decide whether these measures suggest good, bad, or average performance. To make
judgments, we need standards for comparisons. Standards for comparisons can include:
 Intracompany – The company under analysis provides standards for comparisons based on
prior performance and relations between its financial items.
 Competitor – One or more direct competitors of the company under analysis can provide
standards for comparisons.
 Industry – Industry statistics can provide standards of comparisons
 Guidelines (rules of thumb) – General standards of comparisons can develop from past
experiences. These guidelines, or rules of thumb, must be carefully applied since their context
is often crucial.
All of these standards of comparisons are useful when properly applied; yet analysis measures taken
from a selected competitor or group of competitors are often the best. Also, intracompany and
industry measures are important parts of all analyses. Guidelines, or rules of thumb, should be applied
with care, and then only if they seem reasonable in light of past experience and industry norms.
Tools of Analysis
There are several tools of financial statement analysis. Three of the most common tools are:
1. Horizontal Analysis – Comparison of a company’s financial condition and performance across
time.
2. Vertical Analysis – Comparison of a company’s financial condition and performance to a base
amount.
3. Ratio Analysis – Measurement of key relations between financial statement items.
Horizontal Analysis
Our analysis of a single financial item is important but is of limited value. Instead, our financial analysis
needs to use the important relations that exist between items and across time. Much of financial
statement analysis involves identifying and describing relations between items, groups of items, and
changes in those items. Horizontal analysis is a tool to evaluate changes in financial statement data
across time.
There are two (2) types of horizontal analysis:
1. Comparative Statements
2. Trend Analysis
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Comparative Statements
Comparing amounts for two or more successive periods often helps in the analysis of financial
statement data. Comparative financial statements facilitate this comparison by showing financial
amounts side-by-side columns on a single statement. Each financial statement if presented in a
comparative format. Comparative statements can be done using three approaches:
1. Computation of Dollar Changes and Percent Changes – Comparing financial statements over
relatively short time periods-two to three years-is often done by analyzing changes in line items. A
change analysis usually includes analysis of absolute dollar amount changes as well as percent
changes. Both since dollar changes can sometimes yield large percent changes inconsistent with
their importance. For instance, a 50% change from a base figure of $100 is less important than the
same percent change from a base amount of $100,000 in the same statement. Reference to dollar
amounts is necessary to retain a proper perspective and to assess the importance of changes.
We compute the dollar change for a financial statement item as:
Dollar Change = Analysis Period Amount – Base Period
Amount
Where analysis period is the point or period of time for the financial statements under analysis,
and base period is the point or period of time for the financial statements used for comparison
purposes. We commonly use the prior year as the base period.
We compute the percent change by dividing the dollar change by the base period amount and then
multiplying this quantity by 100:
Percent Change (%) =
Analysis Period Amount – Base Period Amount
Base Period Amount
X 100
While we can always compute a dollar change, we must be aware of a few rules in working with
percentages. To illustrate, let’s look at four separate cases in the chart below.
Case No.
A
B
C
D
Base
Period $
(4,500)
2,000
10,000
Analysis
Period $
1,500
(1,000)
8,000
0
Dollar
Change
6,000
(3,000)
8,000
(10,000)
Percentage
Change
(100%)
It is common when using horizontal analysis to compare amounts to either average or median
values from prior periods. Comparing changes to average or median values computed from more
than one prior period highlights unusual happenings, as average values smooth out erratic or
unusual fluctuations. We also commonly round percents and ratios to one or two decimal places.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
But there is no uniform practice on this matter. Computations are as detailed as necessary. This is
judged by whether or not rounding potentially affects user’s decisions. Computations should not
be so excessively detailed that important relations are lost among a mountain of decimal points.
2. Comparative Statement of Financial Position – One of the most useful comparative statements is
the comparative Statement of Financial Position. It consists of amounts from two or more dates
arranged side by side. The usefulness of comparative financial statements is often improved by
showing each item’s dollar change and percentage change. This type of presentation highlights
large dollar and percent changes for decision makers. When the large dollar and percentage
changes are highlighted we then try to identify the reasons for these changes and, if possible,
determine whether they are favourable or unfavourable. We also follow up on items with small
changes when we expected the changes to be large.
3. Comparative Income Statement – A comparative income statement is prepared similar to the
comparative statement of financial position. Amounts for two or more periods are placed side by
side, with additional columns for dollar and percent changes.
Trend Analysis
Trend Analysis, also called Trend Percent Analysis or Index Number Trend Analysis, is used to reveal
patterns in data for successive periods. It involves computing trend percents for a series of financial
numbers. This method of analysis is a variation on the use of percent changes for horizontal analysis.
The difference is that trend analysis does not subtract the base period amount in the numerator. To
compute trend percents we need to:
1. Select a base period and assign each item in the base period a weight of 100%
2. Express financial numbers from other periods as a percent of its base period number.
A Trend Percent, also called an index number, is the amount in the analysis period divided by the
amount of the same item from the base period, multiplied by 100 to get the percent form:
Trend Percent (%) =
Analysis Period Amount
Base Period Amount
X 100
Analysis of trend percents is often aided by graphical depictions. A line graph is usually used to help
identify trends and detect changes in direction or magnitude.
Trend analysis of financial statement items also can include comparisons of relations between items on
different financial statements. For instance, a comparison of revenues with total assets.
An important part of financial statement analysis is identifying questions and areas of concern such as
these. They often direct us to important factors bearing on the future of the company under analysis.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Vertical Analysis
Vertical Analysis is a tool to evaluate individual financial statement items or a group of items of a
specific base amount. We usually define a key aggregate figure as the base, and the base amount is
commonly defined as 100%. For instance, an income statement’s base is usually revenue and a
statement of financial position’s base is usually total assets. Since the sum of the individual items is
also called Common-Size Analysis, which falls into two (2) categories:
1. Common-Size Statements
2. Common-Size Graphics
Common-Size Statements
Comparative statements show how each item has changed over time, but they do not emphasize the
relative importance of each item. We use common common-size statements to reveal changes in the
relative importance of each financial statement item. All individual amounts in common-size
statements are redefined in terms of common-size percents. A common-size percent is measured by
taking each individual financial statement amount under analysis and dividing it by its base amount:
Common-size Percent (%) =
Analysis Amount
Base Amount
X 100
1. Common-Size Statement of Financial Statement Position – Common-size statements express each
item as a percent of a base amount. The base for a common-size statement of financial position is
usually total assets. It is assigned a value of 100%. This implies the total amount of laibilitities plus
equity equals 100% since this amount equals total assets. Next, we compute a common-size
percent for each asset, liability, and equity items where the base amount is total assets. When we
present a company’s successive statement of financial position in this way, changes in the mixture
of assets, liabilities, and equity are apparent.
2. Common-Size Income Statement – Our Analysis usually benefits from an examination of commonsize income statement. The amount of revenues is usually the base amount, and it is assigned a
value of 100%. Each common-size income statement item appears as a percent of revenues. If we
think of the 100% revenues amount as representing one sales dollar, the remaining items show
each revenue dollar is distributed among costs, expenses, and income.
Common-Size Graphics
There are several tools of common-size analysis. Two of the most common are trend analysis of
common-size statements and graphical analysis. The trend analysis of common-size statements is
similar to trend analysis of comparative statements discussed under horizontal analysis.
An income statement readily lends itself to common-size graphical analysis. Revenues affect nearly
every item in an income statement. It is also usually helpful for our analysis to know what portion of
revenues is taken up by various costs and expenses.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Graphical analysis is especially useful in evaluating a statement of financial position. It is helpful in
assessing two important elements: (1) sources of financing including the distribution among current
liabilities, non-current liabilities, equity capital and (2) identification of investing activities including
distribution among current assets and non-current assets.
Common-size statement of financial position analysis is often extended to examine the composition of
subgroups. For instance in assessing liquidity of current assets, it is often important to know what
proportion is composed of inventories, and not simply what proportion inventories are of total assets.
Common-size financial statements are useful in comparing different companies. This is because
financial statements of different companies are recast in common-size format.
But common-size statements fail to reflect the relative sizes companies under analysis. Comparison of
a company’s common-size statements with competitors’ or industry common size statistics alerts our
attention to differences in the structure or distribution of its financial statements, but not their dollar
magnitude. Still, major differences should be explored and explained.
Ratio Analysis
The most common way of comparing accounting numbers to evaluate the performance and risk of a
firm is RATIO ANALYSIS. It is useful as a means of Interpreting Accounting Statements or Financial
Statements Analysis, which helps users to make better decisions. They provide Internal Users, who
are responsible for the strategic and operating decisions of the company, with information helpful in
improving the company’s efficiency and effectiveness in providing products and services. While on the
other hand, External Users rely on the information derived to make better and more informed
decisions. The common goal of these users is to evaluate a company’s performance, which includes (1)
past and current performance, (2) current financial position, and (3) future performance and risk.
Although ratios provide more meaningful information than absolute numbers alone, the ratios are
most useful when analyzed relative to some standard of comparison. That standard of comparison
may be:
1.
2.
3.
4.
Previous Performance of the same company
The performance of a competitor company
An Industry average for the particular ratio.
General Standards of comparisons that have been developed from past experiences
In addition, ratios should be used together with other ratios to give a fair assessment of the company’s
performance as well as an explanation to the results of some ratios.
The interpretation of the ratios as against the comparative standards is necessary to complete the
process of using ratios to analyze financial statements.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Accountants should use ratio analysis for three (3) reasons:
1. They must be familiar with the ways users assess financial information given to them
2. Ratio analysis is helpful for them when participating in operating and financial decisions
3. Independent Auditors use ratio analysis to identify potential audit problems and determine the
specific audit procedures that should be performed.
Ratio analysis assesses four areas of the financial information of a company:
1. Liquidity and Efficiency – ability to meet short term obligations and to efficiently generate
revenues.
2. Solvency – ability to generate future revenues and meet long-term obligations
3. Profitability – ability to provide financial rewards sufficient to attract and retain financing.
4. Market – ability to generate positive market expectations.
Liquidity and Efficiency
Liquidity refers to the availability of resources to meet short term cash requirements, which is affected
by the timing of cash inflows and outflows, along with its prospects for future performance. Our
analysis of liquidity is aimed at a company’s capital requirements. Efficiency refers to how productive a
company is in using its assets. Efficiency is usually relative to how much revenue is generated for a
certain level of assets.
Working Capital and Current Ratio
Working Capital is current assets less current liabilities. A company needs an adequate amount of
working capital to meet current debts, carry sufficient inventories, and take advantage of cash
discounts.
Current Ratio reflects a company’s ability to pay short-term obligations. It relates current assets to
current liabilities as follows:
Current Assets
Current Ratio =
Current Liabilities
A high current ratio suggests a strong liquidity position, but a company can also have a strong a current
ratio that is too high. An excessively high ratio means that the company has invested too much in
current assets. Since current assets don’t normally generate much return on investment, an excessive
investment in current assets is not a sufficient use of resources.
Many users apply a guideline of 2 to 1 current ratio. However this should be assessed in conjunction
with three factors:
1. Type of business
2. Composition of current assets
3. Turnover rate of current asset component
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Acid Test Ratio
Acid Test or Quick Ratio focuses on the current assets composition or those assets that can be
converted quickly to cash to better assess the company’s ability to meet its short term obligations
quickly. Quick assets are cash, short-term investments, accounts receivable, and current notes
receivable.
Quick Assets
Current Assets - Inventory
Acid Test Ratio =
or
Current Liabilities
Current Liabilities
Accounts Receivable or Debtors Turnover
This ratio measures how frequently a company converts its receivables to cash. It may also include
other short-term receivables from customers in the denominator along with AR.
Accounts Receivable or Debtors Turnover =
Net Sales
Average Accounts Receivable
Inventory Turnover
Working capital requirements are affected by how long a company holds inventory before selling it and
one such measure is the Inventory Turnover.
Inventory Turnover =
Cost of Goods Sold
Average Inventory
Days’ Sales Uncollected
Evaluates how frequently a company collects its accounts
Days’ Sales Uncollected =
Accounts Receivable
Net Sales
X 365
Days’ Sales in Inventory
This ratio estimates how long it will take for inventory to be converted into receivables (or cash). If all
sales are on credit Day Sales Inventory are added to Days’ Sales Uncollected to determine how long it
will take for inventory to convert into cash.
Days’ Sales in Inventory =
Ending Inventory
Cost of Goods Sold
X 365
Total Asset Turnover
Total Asset Turnover describes the ability of a company to use its assets to generate sales and is an
important part of operating efficiency.
Net Sales
Total Asset Turnover =
Average Totals Assets
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Receivables:Payables Ratio
This ratio measures the relationship between how much credit is granted by the business to its
customers, that is debtors, and how much credit has been received by the business from its suppliers,
that is, creditors.
Trade Receivables
Receivables:Payables Ratio =
Trade Payables
Receivables: Sales Ratio
This ratio assess how long it takes for our debtors to pay us
Trade Receivables
Receivables: Sales Ratio =
Sales for the Year
X 12
Payables: Purchases – Ratio
This ratio assesses how long it takes a firm on average to pay its suppliers. The calculation is made as
follows:
Trade Payables
Payables: Purchases Ratio =
X 12
Purchases for the Year
Solvency or Financing
Solvency refers to a company’s long-run financial viability and its ability to cover long-term obligations.
One of the most important components of solvency analysis is the composition of a company’s capital
structure. Capital Structure refers to a company’s source of financing. This analysis is concerned with
a company’s ability to both meet its obligations and provide security to its creditors over the long run.
Indicators of this ability include debt and equity ratios, the relation between pledged assets and
secured liabilities, and the company’s capacity to earn sufficient income to pay fixed interest charges.
Debt and Equity Ratio
Debt Ratio assesses the portion of a company’s assets contributed by its owners and the portion
contributed by creditors. It expresses total liabilities as a percent of total assets.
Debt Ratio =
Total Liabilities
Total Assets
The equity ratio provides complementary information by expressing total equity as a percent of total
assets.
Equity Ratio =
Total Equity
Total Assets
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Pledged Assets to Secured Liabilities
This ratio is used to evaluate the risk of nonpayment faced by secured creditors. The information
needed to compute this ratio is not included in the company’s published financial statements. A
generally agreed minimum value is about 2 to 1. But the ratio needs careful interpretation since the
Book Value of Assets used by it does not necessarily reflect amounts to be received in the event of
liquidity.
Book Value of Pledged Assets
Pledged Assets to Secured Liabilities =
Book Value of Secured Liabilities
Times Interest Earned
This ratio’s purpose is to reflect the riskiness of repayments with interest to creditors. The amount of
income before the deduction of interest charges and income taxes is the amount available to pay
interest charges. The larger this ratio, less risky is the company for lenders. A guideline for this ratio
says that creditors are reasonably safe if the company earns its fixed interest charges two or more
times each year.
Income before Interest and Income Taxes
Times Interest Earned =
Interest Expense
Profitability
Profitability refers to a company’s ability to generate an adequate return on invested capital and to use
its assets efficiently to produce profits (and positive cash flows). Return is judged relative to the level
and sources of financing. Profitability is also relevant to solvency. Profitability Ratios attempt to
measure a company’s ability to earn an adequate return relative to sales or resources devoted to
operations (Assets).
Profit Margin on Sales
These ratio measures a company’s ability to earn profits from its sales as well as cover its expenses.
Net Income
Profit Margin =
Net Sales
Gross Profit as a Percentage of Sales =
Gross Profit
Net Sales
x 100
The amount derived from this ratio is the amount of gross profit for every dollar of sales.
Net Profit as a Percentage of Sales =
Net Profit
Net Sales
x 100
The amount derived from this ratio is the amount of Net profit for every dollar of sales.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Return on Total Assets
This ratio expresses income as a percentage of the average total assets available to generate that
income. Because total assets is partially financed with debt and partially by equity funds, this is an
inclusive way of measuring earning power that ignores specific sources of financing.
Return on Total Assets =
Return on Total Assets =
Net Income
Average Total Assets
Profit Margin on Sales
x Total Assets Turnover
OR
Net Income
Average Total Assets
=
Net Income
Net Sales
x
Net Sales
Average Total Assets
Return on Shareholders’ Equity
The return on shareholder’s equity measures the success of a company in earning net income for its
owners.
Return on Shareholders’ Equity =
Return on Ordinary Shareholders’ Equity =
Net Income
Average Shareholders’ Equity
Net Income - Preferred Dividends
Average Ordinary Shareholders’ Equity
Market
Market Measures are useful when analyzing corporations having publicly traded stock. These market
measures use stock price in their computation. Stock price reflects what the market (public)
expectations are for the company. This includes both the return and risk characteristics of a company
as currently perceived by the market.
Price-earnings Ratio
This ratio is used as an indicator of the future growth of and risk related to a company’s earnings as
perceived by buyers and sellers of the stock.
Price-earnings Ratio =
Market Price per Share
Earnings per Share
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Dividend Yield
Dividend Yield is used as a means to compare the dividend-paying performance of different investment
alternatives.
Dividend Yield =
Annual Dividends per Share
Market Price per Share
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Analysis of Financial Statements
Worksheet
Question 1
HOFFMAN CORPORATION
Statement of Financial Position
As at December 31, 2000
Assets
Non Current Assets
Plant Assets
Inventory
Trade Receivables, net
Notes Receivable (trade)
Short-term investments
Cash
Prepaid Expenses
Total Assets
Equity & Liabilities
Ordinary Share, $1 par value
Retained Earnings
Long-term note payable, secured
by mortgage on plant assets
Trade Payables
Accrued wages payables
Income Tax Payable
Total Equity and Liabilities
$
152,300
31,150
28,200
3,500
7,400
9,000
1,650
233,200
90,000
59,800
62,400
16,500
2,200
2,300
233,200
HOFFMAN CORPORATION
Income Statement
For Year Ended December 31, 2000
$
$
Sales
348,600
Cost of Goods Sold:
Inventory 12/31/1999
32,400
Merchandise purchases
227,900
Goods available for sale
260,300
Inventory 12/31/2000
31,150
Cost of goods Sold
(229,150)
Gross Profit
119,450
Operating expenses
(52,500)
Interest expense
(3,100)
Income before taxes
63,850
Income taxes expense
(15,800)
NET INCOME
48,050
Assume that all sales are on credit. On the December 31, 1999, the assets totaled $182,400, ordinary
shares was $90,000, and retained earnings amounted to $31,300
Required
Compute the following: (a) current ratio, (b) acid-test ratio, (c) days’ sales uncollected, (d) merchandise
inventory turnover, (e) days’ sales in inventory, (f) ratio of pledged assets to secured liabilities, (g)
times interest earned, (h) profit margin, (i) total asset turnover, (j) return on total assets, and (k) return
on ordinary shareholders’ equity.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Question 2
THORNHILL COMPANY
Comparative Income Statement
For Year Ended December 31, 2001, 2000 and 1999
Sales
Cost of Goods Sold
Gross Profit
Selling expenses
Administrative expenses
TOTAL EXPENSES
Income before taxes
Income taxes expense
NET INCOME
$
2001
444,000
267,288
176,712
62,694
40,137
102,831
73,881
13,764
60,117
$
2000
340,000
212,500
127,500
46,920
29,920
76,840
50,660
10,370
40,290
$
1999
236,000
151,040
84,960
31,152
19,470
50,622
34,388
6,962
27,376
THORNHILL COMPANY
Statement of Financial Position
As at December 31, 2001, 2000 and 1999
$
$
Assets
2001
2000
Current Assets
48,480
37,924
Long-term investments
0
500
Plant and equipment
90,000
96,000
Total Assets
138,480
134,424
$
1999
50,648
3,720
57,000
111,368
Equity & Liabilities
Current Liabilities
Ordinary Share Capital
Other contributed capital
Retained Earnings
Total Equity and Liabilities
19,480
54,000
6,000
31,888
111,368
20,200
72,000
9,000
37,280
138,480
19,960
72,000
9,000
33,464
134,424
Required
1. Compute each year’s current ratio
2. Compute 2001 and 2000’s dollar and percentage
3. Compute common size statements for each year for both statements
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Consignment Accounts
Lecture Notes
Nature of Consignment
When a trader sells goods directly to a customer, whether they are in his home country or overseas,
these are ordinary sales. However, a trader may send goods to an agent to sell them for him. These
are said to be sent on consignment. The main features are:
1. The trader sends goods to the agent. The goods do not belong to the agent; his job is to sell
them for the trader. The goods are owned by the trader until they are sold. The trader sending
the goods is called the consignor. The agent is called the consignee.
2. The agent will store the goods until they are sold to him. He will have to pay some expenses,
but these will later be refunded by the trader.
3. The agent will receive a commission from the trader for his work.
4. The agent will collect the money from the customers to whom he sells the goods. He will pay
this over to the trader after deducting his expenses and commission. The statement from the
agent to the trader showing this is known as the account sales.
Consignment accounts are found mainly in overseas trade.
Consignor (The Trader’s) Records
For each consignment to an agent a separate consignment account is opened. Think of it as a trading
and profit and loss account for each consignment. The purpose is to calculate the net profit or loss on
each consignment.
Goods consigned and expenses paid by the consignor
Double entry needed:
Goods consigned (a)
Debit Consignment Account
Credit Goods sent on consignment account (Inventory)
Expenses (b)
Debit Consignment Account
Credit Cash Book
Expenses of the Agent (consignee) and sales receipts
When the sales have been completed the consignee will send an “account sales” to the consignor. This
will show:
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
$
Sales
Less Expenses
Commission
TROY J. WISHART
$
xxx
xxx
xxx
Balance now paid
xxx
xxx
The consignor enters these details in his books. The double entry needed is:
Sales (c)
Expenses of consignee (d)
Commission of consignee (e)
Cash received from consignee (f)
Debit consignee’s account
Credit consignment account
Debit consignment account
Credit consignee’s account
Debit consignment account
Credit consignee’s account
Debit cash book
Credit consignee’s account
Example
Wills of London, whose financial year ends on December 31, consigned goods to Adams his agent in
Canada. All transactions were started and completed in 1998.
(a) January 16: Wills consigned goods costing $500 to Adams.
(b) February 28: Wills paid carriage to Canada, $50.
Adams, the consignee, sends an “account sales” on July 31 when all the goods have been sold. It
shows:
(c) Sales amounted to $750
(d) Adams’ expenses were: Import duty, $25.
Distribution expenses, $30
(e) Commission had been agreed at 6% of sales. This amounted to $45
(f) Adams paid balance owing, $650.
Consignment to Adams, Ottawa, Canada
1998
$
1998
$
Jan 16 Goods sent on consign. (a)
500 July 31 Sales (c)
750
Feb 16 Bank: carriage (b)
50
July 31 Adams: Import Duty (d)
25
Distribution (d)
30
July 31 Adams: Commission (e)
45
July 31 Profit on consignment (P&L)
100
750
750
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
1998
Goods sent on Consignment
$
1998
Jan 16 Consignment to Adams (a)
1998
July 31 Adams (consignee) (f)
1998
July 31 Consignment: Sales (c)
Cash Book
$
1998
500
Jan 16 Consignment to Adams:
Carriage (b)
Adams (Consignee)
$
1998
750 July 31 Consignment:
Import Duty (d)
Distribution (d)
Commission (e)
Bank (f)
750
TROY J. WISHART
$
500
$
50
$
25
30
45
650
750
You can see that the main features are:
(a) The consignment account is a trading and profit and loss account for one consignment.
(b) The consignee’s (Adams) personal account is used to show double entry for items concerning him.
All of these details have been shown on the account sales he sent after selling the goods
Consignee’s (The Agent’s) Records
The only items needed in the consignee’s records will be found from the account sales he sent to the
consignor after the goods have been sold.
He does not enter, in his double entry, the goods received on consignment. They never belong to him.
His job is to sell the goods. Of course he will keep a note of the goods but not in his double entry
account records.
The double entry needed is:
Cash from sales of consignment (c)
Debit Cash Book
Credit Consignor’s account
Payment of consignment (d)
Debit Consignor’s account
Credit Cash Book
Commission earned (e)
Debit Consignor’s account
Credit Profit and Loss account
Cash to settle balance shown on account sales (f)
Debit Consignor’s account
Credit Cash Book
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Account Sales
Adams,
Ottawa,
Canada.
July 31 1998
To
Wills
London
$
Sales of goods received on consignment (c)
Less Charges:
Import Duty (d)
Distribution (d)
Commission (e)
Bank Draft Enclosed
25
30
45
$
750
100
650
The double entry accounts in the books of the consignee (Adams) follow:
1998
July 31
July 31
July 31
Bank:
Import Duty (d)
Distribution (d)
Commission transferred to
Profit and loss (e)
Bank (f)
1998
July 31 Wills: Sales (c)
Wills (Consignor)
$
1998
July 31 Bank: Sales
25
30
$
750
45
650
750
Cash Book
$
1998
750 July 31 Wills: Import Duty (d)
July 31 Wills: Distribution (d)
July 31 Wills: To settle account (f)
Profit and Loss Account (Adams)
$
1998
Commission on Consignment from
Wills (e)
LECTURE NOTES
750
$
25
30
650
$
45
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Bad Debts and Consignments
Normally, when an agent sells goods of the consignor he will collect the sale money from the
customer. If the customer does not pay his account, the money in respect of this does not have to be
paid to the consignor.
To make certain he does not have such bad debts, the consignor may pay an extra commission to the
agent. When this happens the money for the debt will have to be paid by the agent even though he
has not collected it. This extra commission is called del credere commission.
Accounting for Incomplete Consignment
Sometimes all the goods consigned to an agent are not sold as at the close of the financial year. For
instance, if goods are sent in September 1997 and the final sales are made in March 1998. When the
consignor prepares his final accounts up to December 31, 1997, there will be an incomplete
consignment at the date of the statement of financial position.
The main difference between a completed consignment at the statement of financial position and an
uncompleted one is that the unsold inventory has to valued and carried down to the following period.
This inventory will appear in the statement of financial position of the consignor as a current asset.
Example
(a) Farr of Chester consigns 10 cases of goods costing $200 per case to Moore in Nairobi on July 1,
1997
(b) Farr pays $250 for carriage and insurance for the whole consignment on July 1, 1997.
Farr receives an interim “account sales” with a bank draft from Moore on December 28, 1997.
(c) Moore has sold 8 cases of goods for $400 each = $3,200.
(d) Moore has paid a total of $150 for landing charges and import duties on receipt of the whole
consignment.
(e) Moore has paid selling costs, in respect of the 8 cases sold, of $160.
(f) Moore has deducted his commission of 10 per cent in respect of the 8 cases sold = 10% x $3,200 =
$320.
(g) Moore encloses bank draft of $2,570. This is made up of (c) $3,200 – (d) $150 – (e) $160 – (f) $320
= $2,570.
Farr now wishes to balance off his consignment account at his financial year end, December 31, 1997,
and to transfer the profit to date to his profit and loss account.
The consignment account will appear as follows:
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
Consignment to Moore
1997
$
1997
July 1
Goods on consignment (a)
2,000 Dec 28
July 1
Bank: Carriage and Insurance (b)
250
Dec 28 More:
Dec 31
Landing Charges & Import Duties (d)
150
Selling costs (e)
160
Dec 31 Commission (f)
320
Dec 31 Profit on consignment to P&L
800
3,680
1998
Jan 1 Value of unsold inventory (b) b/d
Note:
TROY J. WISHART
$
More: Sale of part
consignment (c)
Value of unsold
Inventory (h) c/d
3,200
480
3,680
480
(h) Value of unsold inventory at December 31, 1997:
Goods: 2 cases x $200 each
Add Proportion of expenses belonging to 2
unsold cases out of 10 received
(b) Carriage 2/10 x $250
(d) Landing charges and duties 2/10 x $150
$
50
30
$
400
80
480
There is no proportion of (e) selling costs $160 or (f) commission $320 added to the valuation of the 2
unsold cases. This is because both of these expenses were only for the sale of the 8 cases, and nothing
to do with the 2 unsold cases.
The profit and loss account for Farr for the year ended December 31, 1997 will include the
consignment of $800. The statement of financial position as at December 31, 1997 will include the
consignment inventory of $480 as a current asset.
The consignee’s account, Moore’s, can be show in Farr’s books as:
1997
Dec 28 Consignment: Sales (c)
More (Consignee)
$
1997
3,200 Dec 28 Consignment expenses:
Landing charges etc. (d)
Selling costs (e)
Commission (f)
Bank (g)
3,200
LECTURE NOTES
$
150
160
320
2,570
3,200
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Final Completion of Consignment
When the remainder of the consignment is sold, the consignment account can be closed. This will be
done by transferring the final portion of profit or loss to the consignor’s profit and loss account. The
details will be found in the final account sales which the consignee will have sent to the consignor.
Continuing from the above example:
(i)
(j)
(k)
(l)
The final 2 cases of goods were sold for $380 each = $760
Selling costs of these 2 cases were $70
Commission deducted at 10percent = 10% x $760 = $76.
Bank draft sent for $614. Made up of (i) $760 – (j) $70 – (k) $76 = $614.
Farr’s books:
Consignment to Moore
1998
$
1998
Jan 1
Value of unsold Inventory (h) b/d
480 Mar 31 More: Sale of remainder (i)
Mar 31 More:
Selling costs (j)
70
Dec 31 Commission (k)
76
Dec 31 Profit on consignment to P&L
134
760
LECTURE NOTES
$
760
760
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Consignment Accounts
Work Sheet
Question 1
On February 8, 1998 PJ, a London trader, consigned 120 cases of goods to MB, an agent in New
Zealand.
The cost of the goods was $25 a case. PJ paid carriage to the port $147 and insurance $93. On March
31, 1998 PJ received and “account sales” from MB, showing that 100 cases had been sold for $3,500
and MB had paid freight , at the rate of $2 a case, and port charges amounting to $186. MB was
entitled to a commission of 5% on sales. A sight draft for the net amount due was enclosed with the
“account sales”.
You are required to show the accounts for the above transactions in the ledger of PJ and to show the
transfer to profit and loss account at March 31, 1998.
Question 2
(a) Explain the differences between a consignment and a sale.
(b) 100 cases of goods costing $3,500 were sent on consignment by X Limited to Y Limited on February
1, 1997. At the same time, X Limited paid delivery expenses of $100 and insurance of $20. On
March 1, 1997 an interim “account sales” was received from Y Limited showing that 80 cases had
been sold for $63 each and that storage charges of $180 and selling expenses of $100 had been
deducted from the account. After also deducting the commission on sales which was agreed at 5%
of gross sales, Y Limited settled the balance due to X Limited for goods sold by a bank draft.
Required:
(i) Prepare the interim “account sales”, and
(ii) Prepare the consignment account in the books of X Limited.
Question 3
On November 15, 1998, Hughes consigned 300 cases of wooden items to Galvez of Madrid. On
December 31, 1998, Galvez forwarded an “account sales”, with a draft for the balance, showing the
following transactions:
1) 250 cases sold at $20 each and 50 at $18 each.
2) Port and duty charges $720.
3) Storage and carriage charges $410
4) Commission on sales 5% + 1% del credere.
LECTURE NOTES
UNIVERSITY OF GUYANA
ACT 220 FINANCIAL ACCOUNTING 2
TROY J. WISHART
Required
(a) Prepare the account sales, and
(b) Show the consignment inward account in the books of Galvez. Ignore interest.
Question 4
Stone consigned goods to Rock on January 1, 1998, their value being $12,000, and it was agreed that
Rock should receive a commission of 5% on gross sales. Expenses incurred by Stone for freight and
insurance amount to $720. Stone’s financial year ended on March 31, 1998, and an “account sales”
made up to that date was received from Rock. This showed that 70% of the goods had been sold for
$10,600 but that up March 31, 1998, only $8,600 had been received by Rock in respect of these sales.
Expenses in connection with the goods consigned were shown as being $350, and it was also shown
that $245 had been incurred in connection with the goods sold. With the account sales, Rock sent a
sight draft for the balance shown to be due, and Stone incurred bank charges of $12 on April 10, 1998,
in cashing same.
Stone received a further “account sales” from Rock made up to June 30, 1998, and this showed that
the remainder of the goods had been sold for $4,800 and that $200 had been incurred by way of
selling expenses. It also showed that all cash due had been received with the exception of a debt for
$120 which had proved to be bad. A sight draft for the balance due was sent with the “account sales”
and the bank charged Stone $9 on July 1, 1998, for cashing same. You are required to write up the
necessary accounts in Stone’s books to record these transactions.
LECTURE NOTES